A Dozen Things I’ve Learned from Louis C.K. about Money, Investing and Business

The comedian Louis C.K. was born Louis Szekely in 1967. He began his career writing for other comedians including David Letterman, Dana Carvey, Conan O’Brien and Chris Rock and has created several video series including the FX comedy show Louie, which he wrote, directed and edited. Louis has been a notable innovator in the business of comedy including releasing his debut standup routine Live in Houston directly through his website in 2001. He has also been an innovator in the use of direct-to-fan sales of tickets to his stand-up shows as well as using free video downloads to promote his other work. Most recently, he created and financed the video series Horace and Pete.

  1. “I have a no problem with something going down in flames. I’m not afraid of that. It’s very important to me that it works, but that doesn’t come from fear of failure — failure is okay.”  The entertainment business has a distribution of financial success that reflects a power law. A tiny number of entertainers find huge financial success in the entertainment business, while most everyone else makes a modest living, very little or even virtually nothing. Like venture capital, entertainment is a tape measure home run business. An entertainer like Louis is not going to break through and be financially successful unless he or she swings for the fences and takes risks. Power laws exist because of the tendency of what is popular to get more popular and for anything which loses advantage to lose further advantage. So-called “cumulative advantage” is an example of positive feedback. Positive feedback can also be seen in the technology world. There is also cumulative disadvantage. When things change so rapidly for the better or worse for a company like Blackberry, people can be shocked. Humans are simply not good at understanding exponential change. Nassim Taleb calls this phenomenon “Extremistan.” Some people may say, “Well, Extremistan and cumulative advantage have always been the case.” The difference today is that more systems are digital, which magnifies cumulative advantage or disadvantage. We do not yet know the full societal impact of this Extremistan phenomenon.

 

  1. “You can’t make a show without losing money first…Then there were these stories that say, ‘Horace and Pete lost money.’ And I thought, well, I didn’t lose money. I invested money.  I’m so not broke. I’m so not broke. It’s kind of crazy to see how wrong it gets, and to see how far that wrongness spreads. It’s an interesting pipeline to have tested. Because the interest thing about this show, this experience for me, is that I made a thing that’s usually made by a corporate entity but I don’t have any of the apparatus. We didn’t send out big press releases. We actually avoided the press when we were making the show, so they don’t have any guidance or relationship with us. If Fox or ABC makes a show, they have a staff of people that are all about PR and about handling the press.” “It was just a weird distortion of what I said because I said on Howard Stern that I took on debt. I mean, Howard’s a comedy guy, so I wanted to make it sound funny, and I knew he would laugh if I said I’m in debt… I told him, ‘Yeah, I’m millions of dollars in debt,’ which I was, technically — I took a line of credit to finish the show. But there’s no other way to make a TV show — every TV show that you ever see is running a deficit… I took debt so I could get through production, but I knew that I would make the money back — I knew it.” “The tax rebate we’re getting from New York State and the amount of sales we have so far have put the show in the black.” Louis has talked several times in public about how fast his joke on Howard Stern’s show about losing millions making Howard and Pete series went viral. He believes that the story was particularly “clickable” since it has story elements people love. For example, people want to read stories that indicate great success is followed by failure and vice versa. The less interesting reality behind the fake viral story is a near inevitability: investing requires that money be invested up front. Unless all you are putting in to an investment are talent or sweat equity, cash must go out, before cash comes in. Even if you are not personally putting cash in first before cash comes out, someone else inevitably is funding the business. Charlie Munger once told a humorous story about absolute dollar free cash flow: “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”

 

3. “[Horace and Pete] is paid for — with no advertising. There isn’t a TV show with this kind of cast that has that kind of success. So why the dirty fuckballs did I charge you five dollars for Horace and Pete, where most TV shows you buy online are 3 dollars or less? Well, the dirty unmovable fact is that this show is fucking expensive. The standup specials are much more containable. It’s one guy on a stage in a theater and in most cases, the cost of the tickets that the live audience paid, was enough to finance the filming. But Horace and Pete is a full on TV production with four broadcast cameras, two beautiful sets and a state of the art control room and a very talented and skilled crew and a hall-of-fame cast. Every second the cameras are rolling, money is shooting out of my asshole like your mother’s worst diarrhea. (Yes there are less upsetting metaphors I could be using but I just think that one is the sharpest and most concise). Basically this is a hand-made, one guy paid for it version of a thing that is usually made by a giant corporation. Now, I’m not complaining about this at all. I’m just telling you the facts. I charged five dollars because I need to recoup some of the cost in order for us to stay in production.” It has become quite hard to charge a fee for many types of consumer services since people have become accustomed to getting many services “for free.” When business people say things like: “We are going to start charging a subscription fee” for a product or service they often do so without having the slightest idea about how hard it is to actually do so. Getting people to pay for anything is never easy, but getting them to commit to pay real money is even harder especially if the commitment extends into the future. Five key factors will drive the financial success of any business. They are:

Average revenue per user (ARPU) – How much do customer’s pay?

Customer Lifetime – How long do customers stay?

Cost of capital – What is the rate of return on your next best alternative for investing money?

Gross Margin – What’s left of revenue when you take away the cost of goods sold, divided by the total sales revenue, expressed as a percentage?

Customer Acquisition cost (CAC) – How much was spent to acquire the customer?

Every business can be analyzed in this way.  Louis has been an innovator with respect to many of these factors. For example, he makes his shows in innovative less costly ways, acquires customers more cheaply with less advertising and prices services for value.

 

  1. “The thing that was left out is that I own a television show. I own a complete series. I own it. I’m at the head of the stream. I’m in the mountains. I’m the snow that’s melting to feed the water. It’s an enormous asset and it’s mine forever. That doesn’t exist. You might own a small piece if you get points on your show, which is a hard position to get to even. But I own this thing. I own a show that has Steve Buscemi, Edie Falco, Alan Alda, Jessica Lange, Aidy Bryant.” Hopefully we’ll get Emmy nominations, which I’m going to push for. And then we’ll sell it to Netflix or somebody else or Hulu.” “We’ll sell the show to other services. We’ve got a few offers and we’re kind of not paying attention to them right now… I’d like to spend the rest of the year seeing how it does in the wild, and then when it’s time sell it, I can split these checks with my cast, who all own big pieces of the show.” By financing, making, promoting and distributing a series or other entertainment himself Louis has fewer suppliers who can extract value from his work via “wholesale transfer pricing.” The wholesale transfer pricing concept is important to understand especially if you are in business or an investor. I wrote in a previous blog post:

“Wholesale transfer pricing power is a term I heard John Malone use in a conference room circa 1995.  You won’t find the term in textbooks.  Simply put: Wholesale transfer pricing =  the bargaining power of company A that supplies a unique product XYZ to Company B which may enable company A to take the profits of company B by increasing the wholesale price of XYZ. The term “wholesale transfer pricing power” is similar to, but not the same as, a “hold up problem.” The best lens to look at the wholesale transfer pricing power/supplier hold up set of issues is Michael Porter’s “Five Forces” analysis, specifically “bargaining power of suppliers.”

Every business has a value chain and each element in the value chain is trying to extract value from the value chain. How much anyone gets in that value chain is determined by negotiating leverage. And negotiating leverage is determined by what Roger Fisher calls a BATNA (best alternative to a negotiated agreement), which is essentially an opportunity cost process. If you have only one supplier of an essential component at any point in your value chain (like the music streaming business does), then may God have mercy on your business. Hopefully God will have mercy because suppliers (for example, music owners) will not.

  1. “The advertising budgets on these shows often eclipse the production budgets. They’ll spend millions of dollars on advertising.” “While we’re sitting here, [my show] is selling and selling and selling. So far to date, my advertising budget is zero.” Louis knows what Jeff Bezos knows, which is that these days it is far better to invest in your product than to spend money amplifying your shouting about it. Jeff Bezos:

“The balance of power is shifting toward consumers and away from companies…the individual is empowered… The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it. If I build a great product or service, my customers will tell each other. In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts.” “Your brand is formed primarily, not by what your company says about itself, but what the company does.”

What Louis has done is a smart personal rebellion against the type of ad spending she in this chart below.

 ads

6. “I just make the show, I don’t really get paid a thousand bucks a show. I have a fee but it’s the lowest legal fee that I could possibly take. The skills minimum across the board for SAG, Director’s Guild and all that stuff. But I might get an enormous amount of money on the road because of the show. So that’s the tradeoff.”  Even if Louis takes very little salary for a video series he is still able to use that exposure as advertising or promotion to sell complementary products and services like concert tickets. A term used for this phenomenon is content marketing.  As an example, almost all of the blogs you read are content marketing for something else that is being sold. It could be wealth management that is being sold or venture capital. What people get from content marketing is not always financial. Charlie Munger says that he gives his speeches and talks as a form of penance.

7. “There is fatigue [in creating the shows]. It’s fucking hard. What I know from experience is that if I was getting a million dollars a show it wouldn’t make it easier. It wouldn’t make it more fun.” Work is work. That’s why they call it work. If your work is 100% fun, then you should call it fun, not work. Some work is more fun than other work. Some work pays more than other work. Some work pays a lot and is mostly not fun. Some work is mostly fun and pays a lot. The mix for everyone is different.

 

Pays Well Pay is Lousy
Fun  Top tier  comedian   River rafting guide, most  comedians
Not fun  Proctologist    Migrant fruit picker

 

8. “Everything is amazing right now and nobody’s happy. In my lifetime the changes in the world have been incredible. When I was a kid we had a rotary phone. We had a phone you had to stand next to and you had to dial it. And then when, if you wanted money you had to go in the bank for when it was open, for like three hours.”  Standup comedy delivered on a grassy field in New York’s Central Park is not an effective way to capture revenue since anyone can listen without paying. Louis can’t exclude people who do not pay in that park setting without walls or barriers being constructed. Anyone on the grass can record his performance and transmit it to billions of people. The free experience that consumers get in that situation generates “consumer surplus.” Consumer surplus is the difference between the total amount consumers are willing and able to pay for a product and the total amount that they actually do pay. By contrast, if Louis does standup comedy in a theater, the ticket revenues received from people who desire to be in the building can bring in big loads of cash. In a theater, an entertainer like Louis’s performance is “excludable” in that only people who pay the required fee can attend. That value captured by Louis in a theater is “producer surplus” and can be very significant. For example, in a music setting just five concerts at the Staples Center in Los Angeles generated $8.9 million in box office revenue for Taylor Swift in 2015. The services provided by a business like Netflix are similar to a Louis CK performance in a theater in that they are both designed to create something hard to consume for free. Software running in server in a data center providing a web service is similarly able to capture revenue and profit since users can’t make their own copy of the streamed service just like they can’t see Louis doing stand up in a concert hall without buying a ticket. This matrix below illustrates how “excludable, non-rival” has become a sweet spot for digital business models. In contrast, “non-excludable, non-rival” is a danger zone for profitability.

Excludable

Non-excludable

Rival

Louis CK t-shirt

Unregulated fishing in the ocean

Non-rival

Louis CK in concert in a theater

Digital Louis CK comedy routine obtained via BitTorrent

You may be saying, “Well, I’m not Louis and that solution won’t help me.” This is true, but like him, you will need to adapt your business in order to prosper in this ever-changing world. You will need to think about how you create value and what your own business model will be. What is a business model? I like the definition created by Mike Maples, Jr.: “The way that a business converts innovation into economic value.” Steve Blank has his own view: “A business model describes how your company creates, delivers, and captures value.” One effective way to find a business model is to apply a trial and error process in which the optimal result is discovered via experimentation rather than a grand plan generated from whole cloth. The task of people who create business models is often to take software-based products or services that might otherwise be in the bottom right quadrant of the previous matrix (sometimes called public goods) and moving them into the bottom left quadrant to make them excludable. Software is a non-rival public good, since more people can possess it at no additional cost. The object of the business is to somehow make that public good excludable or attach its use to something complementary that is excludable.

 

  1. “I never viewed money as being ‘my money’ I always saw it as ‘the money.’ It’s a resource. If it pools up around me then it needs to be flushed back out into the system.” Andrew Carnegie famously said that a person who “dies rich, dies disgraced.” In effect, he believed that money is like manure, it does the most good when you spread it around. Of course, you shouldn’t spread it around so much that you are not able to take care of yourself and the people you love. But someone like CK who is spending money to create things people enjoy is a very good thing.

 

  1. “The worst thing you can lose is some money, and money grows back, time doesn’t, that’s what my mom used to say.” The older you get the more you realize that money can’t buy you time. Nothing is more valuable than time. If you are young, trust me on this one.

 

  1. “When people are getting richer and richer but they’re not actually producing anything, it can’t end well.” Why is Louis’s joke funny? I think it is because there is a core of truth involved, like all good humor. If it is not funny to you then you probably do not see any truth. Great comedians are great observers of truth in life. The truth here is similar to Charlie Munger’s point is that simply trading pieces of paper is not a very noble way to make a living.

 

  1. “My bank is the worst. They are screwing me. You know what they did to me? They’re charging me money for not having enough money. Apparently, when you’re broke, that costs money.”  “I had five dollars [in the bank] that I couldn’t have for three days until they charged me another $15. Leaving me with -$10. What does that mean? I don’t even have no money any more. I wish I had nothing. But I don’t have it. I don’t have that much. I have “not ten.” Negative ten dollars. I can’t afford to buy something that doesn’t cost anything. I can only afford to get something that costs ‘you give me ten dollars.'” Being poor is very expensive.  Just one element of that problem is what the poor pay for financial services, which is what Louis is joking about just above.  Facts are:

 

“About 28.3 percent, or one in four American households, are what the FDIC calls “under” or “unbanked.” Underbanked households use a bank account, but also use alternative financial services, such as payday loans or check-cashing outlets. The unbanked don’t use any accounts at all.”… they have to rely on expensive alternatives like non-bank money orders, check-cashing services, prepaid debit cards and payday loans. For the poor, even being lucky enough to have a bank account means high fees. You don’t have enough to meet the minimum balance requirements so you pay a monthly fee that eats away at any money you have.

 

Notes:

Louis CK Web site: https://louisck.net/news/about-horace-and-pete

Link to the Bill Simmons Podcast:  https://soundcloud.com/the-bill-simmons-podcast/ep-92-louis-ck   [Listen to it]

Hollywood Reporter: http://www.hollywoodreporter.com/race/awards-chatter-podcast-louis-ck-891278

Quartz: http://qz.com/688194/the-price-of-ether-a-bitcoin-rival-is-soaring-because-of-a-radical-150-million-experiment/

The Verge: http://www.theverge.com/2016/2/4/10918924/louis-ck-horace-and-pete-money-email

Esquire: http://www.esquire.com/entertainment/tv/news/a44528/louis-ck-debt-jimmy-fallon/

A Dozen Things I’ve Learned from Steven Crist About Investing and Handicapping Horses

You may be wondering: what does horse racing have to do with investing? Charlie Munger answered this question in his famous Worldly Wisdom speech:

“The model I like — to sort of simplify the notion of what goes on in a market for common stocks — is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.”

I never bet on racehorses. Ever. The rake taken by the track is just too high for it to make any sense financially and for me the entertainment value is low. But you can learn important lessons about investing by listening to people who understand horse handicapping. I believe you can learn from just about anyone, which is why I have written blog posts on people like Bill Murray and Rza from Wu-Tang Clan. This blog has two indexes where you can see “old” posts organized by featured individual or topic. These old posts are just as up to date as the new posts. They are written to be as timeless as possible.

In the pari-mutuel  system used by racetracks, the money bet is pooled for each type of bet, the racetrack takes its percentage (the rake), and the remainder is disbursed to the winners in proportion to the amount wagered. Michael Mauboussin further explains in his book More Than You Know:

“One way to think about it is to contrast a roulette wheel with a pari-mutuel betting system. If you play a fair game of roulette, whatever prediction you make will not affect the outcome. The prediction’s outcome is independent of the prediction itself. Contrast that with a prediction at the racetrack. If you believe a particular horse is likely to do better that the odds suggest you will bet on the horse. But your bet will help shape the odds. For instance, if all bettors predict a particular horse will win, the odds will reflect that prediction, and the return on investment will be poor.

The analogy carries to the stock market. If you believe a stock is undervalued and start to buy it, you will help raise the price, this driving down prospective returns. This point underscores the importance of expected value, a central concept in any probabilistic exercise. Expected value formalizes the idea that your return on an investment is the product of the probabilities and the various outcomes and the payoff from each outcome.”

The famous Preakness horse race is being run today and on that Steven Christ has said:

“Exaggerator may provide better betting value as the 3-1 second choice than Nyquist at 3-5.”

This post will explain why professionals focus on finding the better betting value instead of predicting which horse is most likely to win the race. Nyquist can be the horse most likely to win the race and not be the best bet in terms of value. It is magnitude of success that matters in a probabilistic activity, not frequency of correctness.

Steven Crist is the editor and publisher emeritus of the Daily Racing Form, a newspaper that reports on the past performance of race horses. Crist has had a number of jobs in the horse racing industry over the years, including writing about horse racing and the gambling generally as a reporter and columnist for The New York Times from 1981 to 1990. He is the author of several books on horse racing and a 1978 graduate of Harvard. Crist fell in love with horse racing while in college: “The stats and numbers stuff is there. Plus the animals, the gambling—and the weird subculture: the racetrack is…well, like people who ran away and joined the circus.”

The idea for this blog post came from Michael Mauboussin, who I quote in this post and elsewhere extensively. His writing is an amazing resource for investors.

Here are the usual dozen quotes from this week’s featured personality Steven Crist:

 

1. “A good litmus test for someone being a liar and an idiot is if someone ever tells you, ‘I am really good at roulette,’ or ‘I win at craps,” or ‘I have a system for beating the slot machines.’ There is no such thing. These are games with fixed percentages. The casino might as well attach a leach to your forehead when you walk in the door because the longer you stay, the more you will lose, except for short-term, meaningless fluctuations.” There are zero professional roulette players. For similar reasons, I would rather pit a viper down my shirt than play a slot machine. Some people may feel cool when playing craps thinking that they are a modern day member of the rat pack, but craps in a casino is a game for suckers who are bad a math. If you really want to gamble or play cards there are games with better odds.

 

2. “The exceptions to [the previous] rule are blackjack and poker. If you count cards diligently in blackjack, you can get a 1.5 percent edge over the house. Casinos, of course, don’t get built by players having edges, so the casinos will eject you if they figure out that you’re counting cards.” There are a number of investors who counted cards at one time in their life. Card counting was invented by a group of U.S. Army Engineers known as the Four Horsemen. They published their ideas on card counting in a paper in 1957 entitled Playing Blackjack to Win. A mathematician named Ed Thorp improved on that system in his famous book Beat The Dealer. Card counting is now a well-known phenomenon. As just one example of a card counter, the actor Ben Affleck has been banned from several casinos for counting cards.  He said about one incident: “That being good at the game is against the rules at a casino should tell you something about a casino.” As just one example, Affleck has been told to never again play blackjack at the Hard Rock Hotel and Casino.

 

3. “Poker, which is always situated right next to the horse racing area. The reason that you can win at poker and horse racing is the same – you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public. The house is not setting the odds. In roulette, there are 38 spaces on the wheel, and if you pick the correct one, the house will pay you off at 35-to-one, and they will keep the difference. The longer you play, the more you lose and the more the house wins. When the other players are setting the prices, it is an entirely different story because somewhere between frequently, occasionally and rarely, the public makes the wrong price.” Many successful investors also play poker. Michael Mauboussin tells this story which makes an important point about poker:

 

“Jim Rutt, who used to be the CEO of Network Solutions [talks] about playing poker when he was a young man. By day, he would learn about the different probabilities, and look for poker tells and pot odds, and all this stuff, and by night he would play. He played in progressively tougher games, and won some, lost a little. Eventually, his uncle pulled him aside and said, “Jim, it’s time to be less worried about getting better, and more worried about finding easy games.”

 

Warren Buffett put it this way in 2002: “The important thing is to keep playing, to play against weak opponents and to play for big stakes.”

Buffett’s partner Charlie Munger is another  example of someone who learned a lot from poker, including:

 

“Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.”

 

4. “The truth is that only a small number of people are 20% better than the takeout, and that just gets you even. It’s a tough, tough game to win.” I’ve have zero intention of ever betting on a horse race. Charlie Munger says he knows people who beat the odds even with this 20% “rake” by the track.  That may be true, but I’ll pass thank you very much. As I said previously, I just don’t enjoy gambling as entertainment. Some people may enjoy betting on horses or be addicted to it. If they are the former, they need to worry about the latter. Even if there is a tiny probability that I might become addicted to gambling I never want to take that chance given the magnitude of the potential harm. The odds of you seeing me playing roulette or pulling the arm of a slot machine in a casino are zero.

 

5. “The central premise of pari-mutuel wagering, is to get a better price from the other bettors than something deserves to be.” “Recognize the difference between picking horses and making wagers in which you have an edge. The only path to consistent profit is to exploit the discrepancy between the true likelihood of an outcome and the odds being offered.” “If you demand sufficient value to cover the margin of error, you should outperform the competition-your fellow horseplayers.” When Crist talks about “value necessary to cover mistakes” who does that sound like? Ben Graham and his margin of safety. Michael Mauboussin writes: “A positive expected value opportunity has an anticipated benefit that exceeds the cost, including the opportunity cost of capital. Not all such financial opportunities deliver positive returns, but, over time, a portfolio of them will…. An investment is attractive if it trades below its expected value. Expected value, in turn, is a function of potential value outcomes and the probability of each outcome coming to pass. Investing is fundamentally a probabilistic exercise. Investing is the constant search for asymmetric payoffs, where the upside opportunity exceeds the downside risk. Ben Graham described margin of safety as buying an investment for less than what it is worth. The larger the discount, the greater the margin of safety.” Bloomberg writer David Papadopoulos writes that one should seek finding “value” in a horse. He says: “You’re not necessarily looking for the most likely winner, so much as a horse whose odds are longer than they ought to be.”

Venture capital is the extreme case in that the better betting value is determined by how cheaply one can buy optionality. Optionality is sometimes mis-priced and can be bought at a bargain.Those situations tend to be in places where others are not looking and the failure rate is high. I have written two blog posts on optionality which discuss this topic in greater detail.  Jeff Bezos describes the value of mis-priced optionality here:

“Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a 10% chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs.”

“In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”

 

6. “What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation:

 

Price X Probability = Value. 

 

The entire world of investing is that simple too. Here is what I mean. If a horse has a 33 percent chance of winning a race, and if you can get odds of 2-to-1 on him (which means tripling your money), there is no value – the horse is priced correctly. If a horse is 6-to-5 (which means you will only get back 120 percent of your bet) and he is only 33 percent to win, then he is a terrible bet. If you’re going to get 4-to-1 (quintupling your money) on a 33 percent chance winner, then it’s a great bet. People talk about value as if it is a ‘factor’ or an ‘angle’ when in fact it is the definition of success at pari-mutuel wagering.”  The math here is simple, but the many sources of emotional bias make the process fraught with potential problems. And of course determining probability is often not a simple thing and sometimes not even possible. Mauboussin writes:

“We can specify two types of probabilities: objective (or frequency) and subjective. Objective, or frequency, probabilities arise when there are specified outcomes. Coin tosses are a good example. In these cases, the probability is based on the law of averages as it assumes that the event is repeated countless times. While we still can’t make definitive statements about any specific outcome, the frequency of outcomes will reflect the probability of each outcome over time. The circumstances are totally different for events that only happen once, a valid assumption for stock investing. Here, we must rely on subjective probabilities. Subjective probabilities describe an investor’s “degree of belief” about an outcome. These probabilities are rarely static, and generally change as evidence comes along. Bayes’s Theorem is a means to continually update conditional probabilities based on new information. Bayesian analysis is a valuable means to weigh multiple possible outcomes when only one outcome will occur.”

Of course there is also what Richard Zeckhauser calls “ignorance” when you do not know the potential future states of the world and probability therefore cannot be computed.

 

7. “The point of this exercise is to illustrate that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. A horseplayer cannot remind himself of this simple truth too often.” Michael Mauboussin writes: “Some high-probability propositions are unattractive, and some low-probability propositions are very attractive on an expected-value basis.” Charlie Munger talks about the need to understand probability and statistics here:

 

“So you have to learn in a very usable way this very elementary math and use it routinely in life – just the way if you want to become a golfer, you can’t use the natural swing that broad evolution gave you. You have to learn to have a certain grip and swing in a different way to realize your full potential as a golfer. If you don’t get this elementary, but mildly unnatural, mathematics of elementary probability into your repertoire, then you go through a long life like a one-legged man in an ass-kicking contest.”

 

8. “Do you really think this way when you’re handicapping? Or do you find horses you ‘like’ and hope for the best on price?  Most honest players will admit they follow the latter path. This is the way we all have been conditioned to think: Find the winner, then bet. Know your horses and the money will take care of itself. Stare at the past performances long enough and the winner will jump off the page. The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as ‘liking’ a horse to win a race, only an attractive discrepancy between his chances and his price. It is not enough to lose enthusiasm when the horse you liked is odds-on or to get excited if his price drifts up. You must have a clear sense of what price every horse should be, and be prepared to discard your plans and seize new opportunities depending solely on the tote board.” What the investor wants to find is a substantially mis-priced bet. The objective is not to maximize the frequency of betting on winner but to maximize the magnitude of total winning bets.  Munger:

“Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don’t get a big edge often. Opportunity comes, but it doesn’t come often, so seize it when it does come.”

“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”

“It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.”

9. “I’m usually looking to beat favorites because that’s how you make scores, and making scores quicker than you give them back is how you come out ahead.” Investing is the search for mistakes says the famous investor Howard Marks and one big mistakes people make is following the crowd. Sometimes a mis-priced bet can be found by being contrarian. Not always but sometimes.Often the mis-priced bet is caused by a bias that impact humans.  For example, Professor Thaler has a paper on long shot bias that is worth reading (link in the Notes below). There is little “value” in just betting on favorites to win due to the rake by the track.

“The favorite-long shot bias is an observed phenomenon where on average, bettors tend to overvalue “long shots” and undervalue favorites. That is, in a horse race where one horse is given odds of 2-to-1, and another 100-to-1, the true odds might for example be 1.5-to-1 and 300-to-1”

 

10. “A lousy handicapper, who bets on hopeless horses or takes the worst of prices, has no shot. A decent handicapper who makes idiotic bets won’t do much better. A ton of players consider themselves excellent handicappers and poor bettors or money managers, but I think they may be kidding themselves by rationalizing their losses this way.” “How often have you or a fellow trackgoer opined that you’re a pretty good handicapper but you really need to work on your betting strategies or your so-called money management? This is sometimes an exercise in denial for people who are in fact bad handicappers, but it is probably true for many who can select winners as well as anyone. The problem with this line of thinking is that it suggests betting is some small component of the game, which is like pretending that putting is a minor part of championship golf. In fact, if you handicap well and bet poorly, you’ve failed. It’s as useless as crushing your tee shots while three-putting every green.” Michael Mauboussin in these three quotations elaborates on by Crist says better than I ever could:

 

“Money management is all about determining the right amount of capital to allocate to an investment opportunity, given the edge and the frequency of such opportunities.

“Position size is extremely important in determining equity portfolio returns.”

“The first rule of money management is to “live to see another day.” Say you see a 50-1 event priced as if it’s 100-1. That is an attractive opportunity, but you surely wouldn’t bet your net worth on it. Two types of investments are worth looking out for. The first is a positive expected value investment with a high probability of loss. A portfolio of these investments is attractive, but betting too much on any single idea is poor money management. The second is the one with a high probability of gain but significant downside risk. These investments are luring even though they have a negative expected value. Eventually, time assures that investors seeking these opportunities do poorly (witness Long Term Capital Management). A related concept in money management is that it is not the frequency of correctness that matters, but the magnitude. Behavioral finance emphasizes that humans like to be right. Many positive expected value investments have a high frequency of a small downside and a low frequency of large upside. Such investment opportunities may be systematically mis-priced, reflecting inherent human bias. Another rule of money management is the larger the margin of safety, the more you should invest. More attractive investments should receive a greater percentage of the funds. While most portfolio managers have legitimate constraints on how much they can invest in any single idea, too frequently their asset allocation does not distinguish sufficiently for the relative attractiveness of various stock.”

 

In managing money many investor look to the Kelly criterion, a formula used to determine the optimal size of a series of bets.  Munger has recommended a book, Fortune’s Formula by William Poundstone on the subject. The Kelly criterion or formula can be expressed as follows:

kelly formula Credit http://www.pinnaclesports.com/en/betting-articles/betting-strategy/how-to-use-kelly-criterion-for-betting

The formula reveals the expected value of any bet including an investment. Robert Hagstrom points out that many investors use what is called “a fractional Kelly.”  One popular approach is a “half Kelly” in which the wager is half of the Kelly bet.

Munger at the 2006 Wesco meeting said when asked about whether he uses the Kelly criterion:

“The first time I read about that sizing system, my take was that it seemed plausible to me, but I haven’t run that formula through my head – and I won’t. You couldn’t apply it to the investment operations I’ve run [I think because of Berkshire ’s size], but the gist of it in terms of sizing your bet makes sense. Whoever developed that formula has an approach to life similar to mine.”

 

11. “The horseplayer who wants to show a profit must adopt a cold-blooded and unsentimental approach to the game that is at variance with both the ‘sporting’ impulse to be loyal to your favorite horses and the egotistical impulse to stick with your initial selection at any price. This approach requires the confidence and Zen-like temperament to endure watching victories at unacceptably low prices by such horses.” Most mistakes are psychological or emotional. For all of the reasons Munger talks about in his famous Psychology of Human Misjudgment speech people make mistakes. Munger puts it this way:

 

“Now if the human mind, on a subconscious level, can be manipulated that way and you don’t know it, I always use the phrase, “You’re like a one-legged man in an ass-kicking contest.” I mean you are really giving a lot of quarter to the external world that you can’t afford to give.”

 

12. “So many of the bad gamblers—the people who should be pulling handles on slot machines — have left racing for casinos that one of the great regrets of current horseplayers is: ‘Where did all the suckers go?’ You want to be betting against people who are betting based on colors and jockeys and hunches.” Alpha or the amount that an investor may earn above the market return is a zero-sum game. Only in Lake Woebegone can more than half of the people be above average. This is why Howard Marks says that “In order for one side of a transaction to turn out to be a major success, the other side has to have made a big mistake.” After costs alpha is a negative-sum game. As John Bogle says: “investors as a group must fall short of the market return by the amount of the costs they incur.” Beta, or the market return is not a zero-sum game. As the economy grows everyone can rise with the tide, some of course more than others and some talking a loss anyway. As more investors move to index funds, there are less mistakes and less total opportunity for outperformance. On the topic of why people make mistakes I can’t resist one final quote from Crist about people looking for clues in factors that do not matter:

“It will be interesting to see what kind of narrative NBC Sports will try to weave around the sport during its Preakness telecast after its Derby Day premise was so wrong. Two weeks ago, we were told that American Pharoah’s Triple Crown had ushered in a renaissance in the sport, prompting increases in handle, television ratings, and the size of the foal crop. (Never mind that the 2016 crop was bred before the 2015 Triple Crown.) Then the rest of the theory fell apart when ratings and handle on this year’s Derby declined rather than increased.

Here’s my premise: There’s going to be a good horse race, many people will watch and wager, and the precise size of the crowd, handle, and Nielsen ratings will signify absolutely nothing.”

 

Here’s the rest of Charlie Munger’s explanation of why investing shares attributes with horse racing from his Worldly Wisdom Speech.

 

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it’s very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you’ve got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work. Given those mathematics, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge, because lots of people who don’t know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take. Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the full 17%.

I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness races…. Now, harness racing is a relatively inefficient market. You don’t have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house—which I presume was around 17%—he made a substantial living. You have to say that’s rare. However, the market was not perfectly efficient. And if it weren’t for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. It’s efficient, yes. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.

The stock market is the same way—except that the house handle is so much lower. If you take transaction costs—the spread between the bid and the ask plus the commissions—and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.

How do you get to be one of those who is a winner—in a relative sense—instead of a loser? Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. They’re sending money out net after the full handle—a lot of it to Las Vegas, by the way—to people who are actually winning slightly, net, after paying the full handle. They’re that shrewd about something with as much unpredictability as horse racing. And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mispriced be—that they can occasionally find one.  And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.  That is a very simple concept. And to me it’s obviously right—based on experience not only from the pari-mutuel system, but everywhere else.”

Notes:

Crist on the Preakness:  http://www.drf.com/news/crist-new-factors-likely-change-little-preakness

Harvard Magazine Profile: http://harvardmagazine.com/2010/03/horseplayer-extraordinaire

Crist on Value http://www.funnyeconomist.com/CRIST%20ON%20VALUE.doc

Handicapping Lessons https://medium.com/@onehorsestable/handicapping-lessons-from-the-world-of-poker-70c71a3a0934#.3vk01ezct

Crist Column http://www.valueinvestingworld.com/2008/01/steven-crist-publisher-and-columnist.html?m=1

Mauboussin- Size Matters  http://www.pmjar.com/wp-content/uploads/2013/05/Size-Matters-Mauboussin.pdf

Mauboussin- More than You Know  http://www.amazon.com/More-Than-You-Know-Unconventional/dp/0231138709

Puggy Pearson’s Prescription  http://documents.mx/documents/puggy-pearsons-prescription.html

The Racetrack and Equity Markets http://tabbforum.com/opinions/two-pari-mutuel-environments-the-racetrack-and-equity-markets-how-different

Thaler Paper: http://faculty.chicagobooth.edu/Richard.Thaler/research/pdf/parimutual%20betting%20markets.pdf

Munger Worldly Wisdom  http://old.ycombinator.com/munger.html

Munger Psychology of Human Misjudgment http://www.rbcpa.com/Mungerspeech_june_95.pdf

A Dozen Things I’ve Learned from Josh Kopelman about Investing and Business

I am going to let the subject of this post introduce himself:

“I am Josh Kopelman and I am a partner at First Round Capital, a seed-stage venture firm. Before that I was an entrepreneur, founding and exiting three companies (one IPO, two acquisitions). I’m based in Philly – but First Round invests nationally, and our biggest office is in San Francisco. My fund has invested in the first rounds of companies like Square, Warby Parker, Uber, On Deck Capital, Appnexus, Flatiron Health, Birchbox, and Blue Apron. First Round is laser-focused on helping seed stage companies become the next big thing.”

Moving on to the usual dozen quotes:

  1. “We’re seed stage investors – and like to invest in the ‘first round’ – so we’d rather meet with an entrepreneur earlier than later. (Caveat being that an entrepreneur should have selected an idea they want to pursue – and be willing to pursue it fulltime).” First Round has adopted what has become known as a “platform” approach to seed stage investing which involves providing more resources and operational support to businesses in the portfolio than was traditionally the case. When you are trying to add platform value or otherwise it is  easier to work with someone who has not made problematic business decisions already. In another blog post I wrote: “…it is easier to train people about the right approach than to change what has already been established. The cynic might say this is because valuations are lower for the ‘first dollar in’ venture capitalist. The non-cynic would reply that the probability of success goes up when a business gets a great start, since that helps retire risk and uncertainty.” On the other point made by Kopelman it is surprising how often I talk to people who think they can get professional venture capital backing while working only part time on top of a full time day job. The best venture capitalists want the entrepreneur “all in” and pursuing the business opportunity full time. Missionaries are easier to spot since they are obsessed with the business and want to go at it full time. Mercenaries are more inclined to hedge their commitment.

 

  1. The typical founder spends their time either: PICKING an idea, STARTING a company (hunting for product market fit), or SCALING a company (growing).   Most founders spend <5% of their time on idea selection, yet I believe that ‘the pick’ accounts for >50% of startup success/failure. Observation #1) Many founders rush ‘the pick’. If you’re spending the next 5-10 yrs of your life doing something, pick your idea wisely. Observation #2) In my experience, serial entrepreneurs are more likely to rush the pick due to high self-confidence & easy access to $$.” Kopelman sets out a clear taxonomy with “pick,” “start” and “scale” categories. Each stage  has its own challenges. Warren Buffett agrees with Kopelman on the value of picking the right category: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Some businesses have terrible economics and “picking” those areas can be problematic to say the least.  It is a good idea to be half-crazy when picking an idea so there is sufficient undiscovered optionality, but being fully crazy is unwise. Some things that seem nuts, are actually nuts. And some are not. “Half nuts,” like Goldilocks final sleeping spot, is typically “just right.” I discussed the product market fit and scaling stages in other posts like the one on Eric Ries.

 

  1. “Starting a company is lonely. Every day you wake up and there are more unanswered questions and more decisions to make. Find a community of like-minded people because together, you’re able to answer these questions far more effectively than individually.”  “You’ll benefit from having a confidant, to work through doubts with and together determine the 90% of advice from investors and customers you should ignore.” There is nothing quite like having a conversation with someone you trust to help you think things through. That process is a lot like writing down your ideas in that you can discover things you have not thought through and also generate new ideas. Having colleagues around you is particularly valuable since there are no formulas for success. If there were formulas for success everyone would be rich.

 

  1. “We see a ton of consumer companies who say, ‘We’ll just make it viral’. It’s hard to achieve virality. If there was a virality button, if there was virality dust, then no one would spend a dollar on advertising. Viral is not easy. It’s hard and it has to be built into your product. The best viral apps are built around viral mechanisms. The same thing applies to community. Building a community isn’t easy. You can’t sprinkle community dust on it.” Selling anything is hard. Actually asking for the order and generating cash from a sale is something best appreciated by doing it. For real. Anyone who has actually done this understand that salespeople earn big salaries for a good reason. Sales is not only a real skill but a scarce skill in terms of people who can do it well. Having a product that sells well with little effort requires that a lot of value be delivered versus preexisting alternatives. Usually an offering that is viral has a process that enables the customer to self-educate. The best way to get people to tell their friends is to have a really great product. The essence of business is the ability to cost effectively acquire customers. The very best businesses acquire customers “organically” without advertising. Great products and word of mouth drives sales at these businesses. By contrast, companies which must sell their wares with huge advertising budgets are losing their edge. Jeff Bezos says it best:

 

“The balance of power is shifting toward consumers and away from companies. The individual is empowered. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it. If I build a great product or service, my customers will tell each other….In the old world, you devoted 30% of your time to building a great service and 70% of your time to shouting about it. In the new world, that inverts.”   “Your brand is formed primarily, not by what your company says about itself, but what the company does.”

 

  1. “Every business plan is wrong.  The moment an entrepreneur hits ‘save’ or ‘print’ the plan is out of date.  Things change.” “I’ve always said that I’d much rather bet on an entrepreneur who can adapt to change rather than an entrepreneur who is convinced that they have the ability to predict the future. But adapting to change is hard.  How do you maintain flexibility yet still preserve a goal oriented culture?” The quotation “Planning is essential, but plans are not” is attributed to a number of famous people. The quote has many variations in terms of the words used but the central point is always the same. The important take away is: things inevitably change and being able to adapt is essential. Mike Tyson version is: “Everybody has a plan until they get punched in the mouth.” The Jeff Bezos quote is:  “Any business plan won’t survive its first encounter with reality. Reality will always be different. It will never be the plan.”

 

  1. “You should target 18 to 24 months of runway post Series Seed. The best time to raise follow-on capital is when you don’t need it, and 2 years of runway gives you the best chance to land in that situation.” “It used to be private companies would aspire to go public. We’re at the rare moment in time it’s the opposite. The minor league ball players are getting paid far more than the MVP major league players. Until that works itself out in the market it’s gonna create a really challenging time for these companies valued in the private markets to realize anything in the public markets.”  Never ever run out of cash. Ever. You can recover from lots of bad situations but an absence of cash is nearly always fatal for equity holders and at least very painful for debtors. Having a margin of safety with respect to cash is a wise idea for that reason. Raising money before you need it is also wise since at that point you still have leverage in negotiating with investors. No cash, no BATNA. Having cash also gives a business optionality (huge upside, limited downside). In an uncertain world, that optionality is very valuable. Having the option to dial down spending to deal with the inability to generate new cash does not mean a business should not be aggressive. Instead it means the business has an option if things turn sour.A business always need to be careful, but sometimes that is more more true than other times. The ability of a given business to raise new cash can be easy or hard. venture capital is a cyclical business. In February of 2016 First Round put out a memo to its portfolio businesses that said:

“During the meeting, there was a conversation about the rapidly changing funding landscape. And one of the company’s (bullish) later stage investors warned the founder that the company should no longer rely on raising additional follow-on financing, saying, “We need to act like we’re Mark Watney in the Martian. We can’t assume we will get a shipment of new potatoes to save us.”

  1. “I don’t think a lot of people have been entrepreneurial about venture capital.” “Everyone knows that a VC’s job is to ‘pick’ amazing founders and companies. The best VCs are great pickers. But I think that startup founders have to be even BETTER pickers than VCs. VCs can pick dozens of companies, founders pick one at a time,. The typical VC spends most of their time doing one of three things: SOURCING companies, PICKING companies or HELPING companies. While VC’s probably spend less than 5% of their actual time on the picking, I believe the ‘pick’ creates well over 80% of the return. Good VCs are great pickers. The best VCs are great pickers and excellent mentors.” Venture capital is itself a business and it is only natural that new approaches will be developed as more entrepreneurs like Kopelman get involved. Venture capital was already changing but new blood is acting like an accelerant. There are aspects of the venture business that are unlikely to change (e.g., buying underpriced optionality) and some aspects that are more likely to see changes (how venture capitalists interact with entrepreneurs. We have already seen different approaches to governance, stage focus and entrepreneur support and more experiments and changes are likely. With regard to picking, the nature of picking is that you don’t know the 30 to 40% that will be a total loss. But that does not mean that picking is any less important. The venture capitalist must have 30-40 bets that all have great optionality. One of those bets must return the fund. Two or three more must return it again. As Kopelman says in a quote below, “In order to get a 20% return in 6 years, they need to triple the fund.”  That is part of the inescapable math of the venture capital business. Let’s be clear: tripling a $400 million fun in 6 years is not easy.

 

  1. “Get to know entrepreneurs and who’s best equipped to ‘fill in cells’, seeking out the market and customer data they need to de-risk their business. Look for the ‘heat seeking missiles’ that aim at a target, but constantly scan the environment and adjust course as they separate signal from noise.” Lots of things need to be figured out and invented as a business is created. And in figuring things out there is no manual for success. There are no formulas. People who seek out answers in order to “fill in cells” as problems arise are the ones who succeed. Kopelman is saying there is a premium on inventiveness and good judgement, both of which have big and valuable optionality. Retiring risk is something a great entrepreneur does every day.

 

  1.  “Start off with smaller checks than you expect to write and view them as tuition.” The venture business takes time to learn. Any new venture capitalist will make mistakes, especially at first. Those mistakes will have a monetary cost, but Kopelman is saying that it is a necessary way to learn (i.e., it is tuition). There is no way to learn to be a good venture capitalist without making mistakes. Good judgement comes from experience which often comes from bad judgement. If you are not aware of your mistakes you will not learn. This is part of the reason why Charlie Munger says that he celebrates his own stupidities. Munger says: “I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn. I like people admitting they were complete stupid horses’ asses.” He does not mince word when it come to his own mistakes. Munger says this because as Feynman said the easiest person to fool is yourself. Munger puts it this way: “I think part of the popularity of Berkshire Hathaway is that we look like people who have found a trick. It’s not brilliance. It’s just avoiding stupidity. The amazing thing is we did so well while being so stupid.” Munger is harder on no one than he is on himself and that’s very intentional. He will say straight up that he was a fool or a horse’s ass when he has made a mistake. His point is simple: never stop learning since the process is extremely competitive. Outperforming the market average is a zero sum game. Outperformance must happen in a a brutal Darwinian process dominated by the best professional investors. To actually outperform the market average you need to being your “A game” and that means constant learning and adaptation to a changing environment. You will need every possible edge you can get which is why Munger  advises  that investors acquire “worldly wisdom.”

 

  1. “Your business [may not] fit venture return profiles (but still may be big for you!) or [perhaps] they’re just not into the team (which they’ll never tell you!).”  “Choose bigger ideas. Ideas that, in the success case, the scale is massive and the impact can be large. Chances are you won’t succeed but, if you do, the prize is worth playing for.” Not every business should raise venture capital. Sometimes it is a far better idea to bootstrap a business. It’s perfectly fine and in fact normal to not have venture capital backing and start a business. Most businesses do not need venture capital. If someone does decide to raise venture capital the idea should have massive potential upside since without that it does not have the requisite optionality (huge upside, limited downside). Not every business has the potential for a 50X or more return. That is not only fin but can give the person starting the business a greater dose of what Nassim Taleb calls “antifragility.”

 

  1. “We bust our ass to try to get lucky.” If you can hustle, work and apply skill to alter the probability of success, the change being caused by those actions is not luck. What Kopelman is saying humorously is that hustle, skill and hard work can pay big dividends. Michael Mauboussin writes:”There’s a simple and elegant test of whether there is skill in an activity: ask whether you can lose on purpose. If you can’t lose on purpose, or if it’s really hard, luck likely dominates that activity. If it’s easy to lose on purpose, skill is more important.”

 

  1. “A company’s outcome should drive VC returns.  When VC’s required returns drive company’s outcomes, it’s a recipe for trouble.” “Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund — or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, Myspace and Youtube in the same fund – they would be just halfway to their goal.  Seriously?  A decade ago, any one of those deals would have been (and should have been) a fundmaker!  As a result of this new math, VC’s end up super-focused on the longbets (or moonshots) and frequently remove optionality for mid-tier exits. It is because of the challenges of ‘VC math’ that First Round Capital chose to raise a relatively small fund — allowing us to continue to make initial investments that average $600K.  I understand the importance of aligning one’s time and capital to the upside opportunity, and recognize that there is some minimum threshold of ownership that is required for a VC to commit the time and attention to an opportunity.  Does it make sense for an investor to spend the time and join the board of a company they own 2% of ? Probably not.  However, the difference between 25% and 20% ownership — or even the difference between 20% and 10% — should not prevent a VC from investing in a promising opportunity.”  The interests of the company and the investors are not always fully aligned. The best venture capitalists put the interests of the portfolio business first and they don’t get involved in a business where they can’t do that. This is easy to say but sometimes tricky to do in practice. On this issue and others any entrepreneur’s best source of information on potential  venture investors is other entrepreneurs. Entrepreneurs should do due diligence on their potential investors. The first part of the quotations above from Kopelman relate to the level of returns needed to make a venture capital fund a success. You don’t turn $400 million into $1.5 billion in just six  years investing in a new hockey rink. The venture capitalist needs to find business opportunities that may generate tape measure financial home runs. The only way to do that is to find highly mis-priced optionality. My post “The Best Venture Capitalists Harvest Optionality” discussed that set of issues:   https://25iq.com/2014/04/05/the-best-venture-capitalists-harvest-optionality-dealing-with-risk-uncertainty-and-ignorance/  But a recent Jeff Bezos quote says it best:

“Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”

 

Notes:

Company Math vs. VC Math  http://redeye.firstround.com/2009/10/company-math-vs-vc-math.html

Buy When There’s Blood in the Streets” and Other Lessons from Venture Capitalists Fred Wilson and Josh Kopelman  http://beacon.wharton.upenn.edu/entrepreneurship/2013/02/buy-when-theres-blood-in-the-streets-and-other-lessons-from-venture-capitalists-fred-wilson-and-josh-kopelman/

Let’s just add in a little virality http://redeye.firstround.com/2009/11/lets-just-add-in-a-little-virality.html

Your Business Plan is Wrong http://redeye.firstround.com/2006/10/your_business_p.html

The Watney Rule for Startups — and the Return to the ‘Old Normal’ https://medium.com/@firstround/the-watney-rule-for-startups-and-the-return-to-the-old-normal-cba75583365e#.6iqmrx1vb

Vator Interview http://vator.tv/news/2014-01-02-josh-kopelman-on-the-changing-vc-landscape#EsY3YWbVr0KhcLBp.99

Venture Fizz https://venturefizz.com/blog/stubbornness-optimism-storytelling-discussion-josh-kopelman

Product Hunt https://www.producthunt.com/live/josh-kopelman-2

Techcrunch  http://techcrunch.com/2016/05/09/lps-are-feeling-the-pressure-of-startups-not-finding-exits/

Mauboussin- The Success Equation:  http://www.amazon.com/Success-Equation-Untangling-Business-Investing/dp/1422184234

A Dozen Things I’ve Learned from Bernard Baruch about Investing

One of the more legendary characters in the history of investing is Bernard Baruch. In his biography Jim Grant writes that Baruch was not as wealthy as most people imagine, but wealth enough to live the lifestyle “of a millionaire” (whatever that means).  At various times in his life Baruch was an investor, philanthropist, statesman, and political consultant. The Dictionary of American Biography provides background:

In 1891 Baruch joined the brokerage firm of A. A. Housman and Company as a bond salesman and customers’ man. After some initial setbacks his personal speculations resulted in a series of successful plunges in sugar, tobacco, and railroad stocks. Baruch played a lone hand, followed his hunches, and achieved his greatest triumphs during bear markets, selling short as stock prices tumbled. His flamboyance did not gain him respectability among the Morgans, Warburgs, and other pillars of New York’s financial establishment, but he was a millionaire at thirty. In 1903 Baruch left Housman to establish his own firm. In frequent alliance with the Guggenheim brothers he speculated in copper, sulfur, gold, rubber, tungsten, zinc, and iron investments in the United States and abroad.

Baruch was influenced by several other investors, one of which was Scottish journalist Charles Mackay, the author of Extraordinary Popular Delusions and the Madness of Crowds.

Ben Graham was so successful early in his career as an investor that he was invited to be a partner of an older and more established Bernard Baruch. A passage of the book A Decade of Delusions provides backgrou8nd on this time in history:

At the quarter-century mark of 1925, the great bull market was under way, and Graham, then 31, developed what he later described as a “bad case of hubris.”  During an early-1929 conversation with business associate Bernard Baruch (about whom he disparagingly observed, “He had the vanity that attenuates the greatness of some men”), both agreed that the market had advanced to “inordinate heights, that the speculators had gone crazy, that respected investment bankers were indulging in inexcusable high jinks, and that the whole thing would have to end up one day in a major crash.”  Several years later he lamented, “What seems really strange now is that I could make a prediction of that kind in all seriousness, yet not have the sense to realize the dangers to which I continued to subject the Account’s4 capital.”  In mid1929, the equity in the “Account” was a proud $2,500,000; by the end of 1932, it had shrunk to a mere $375,000.

Graham declined the invitation to join Baruch as a partner. But if you look at what Baruch said over the years it is impossible to conclude that he did not have a significant influence on Graham and the creation of the value investing system. The dozen quotes I have chosen below were chosen to help make this point.

 

  1. “Before you buy a security, find out everything you can about the company, it’s management and competitors, it’s earnings and possibilities for growth.” Treat a share of stock as a proportional ownership of the business. A share of stock is not the equivalent of a baseball card or a collectable car. It is a real business that you must understand deeply to be a successful investor. For someone like Buffett this process of learning about the business is the most fun part of investing.  If you do not find understanding businesses interesting, I suggest that you find a low cost diversified portfolio of index funds/ETFs and be content with your profession and hobbies.
  1. “Don’t try to buy at the bottom and sell at the top. This can’t be done – except by liars.” “Bears can make money only if the bulls push up stocks to where they are overpriced and unsound.” “Whatever men attempt, they seem driven to overdo. When hopes are soaring, I always repeat to myself that two and two still make four.” “The main purpose of the stock market was to make fools of as many people as possible.” Make bi-polar Market your servant rather than your master. Trying to time markets in the short term is a fool’s errand. People, of course, fib about their success as stock speculators all the time — mostly to themselves. Mr. Market is a drunken psycho. Markets are not wise in the short tern nor always efficient. He  is the source of opportunity since his bi-polar swings up and down produce the mis-pricing that allows some people to beat the market.
  1. “When beggars and shoeshine boys, barbers and beauticians can tell you how to get rich it is time to remind yourself that there is no more dangerous illusion than the belief that one can get something for nothing.” There is a big difference between investing and speculating.  Investors are focused on value whereas speculators are focused on how the changing psychology of large numbers of people impacts price. In order to buy a stock at a discount to value you must do the work.  Of course, if it is not work but fun to understand businesses then you have what Warren Buffett likes so much- something that is both profitable and fun.
  1. “In the search for facts I learned that one had to be as unimpassioned as a surgeon. And if one had the facts right, one could stand with confidence against the will or whims of those who were supposed to know best.” Being rational is the fourth bedrock principle of value investing.  Charlie Munger calls rationality “a moral duty.” Unfortunately, it is hard to be rational all the time and in all situations given the many human biases that have been identified by behavioral economists. Even though it is not easy to be rational, it is worth the effort, especially in investing.
  1. “Don’t try to be a jack of all investments. Stick to the field you know best.” This statement by Baruch is another way of saying: stay within your circle of competence. Risk comes from not knowing what you are doing. Charlie Munger says: “There are a lot of things we pass on. We have three baskets: in, out, and too tough…We have to have a special insight, or we’ll put it in the ‘too tough’ basket. All of you have to look for a special area of competency and focus on that.”
  1. “Don’t buy too many different securities. Better to have only a few investments which can be watched.” Baruch is saying that he is a “focus investor” like Charlie Munger: “Our investment style has been given a name — focus investing — which implies 10 holdings, not 100 or 400.” Especially if you have a day job there are only so many business you can genuinely follow and understand.
  1. “Beware of barbers, beauticians, waiters – of anyone – bringing gifts of ‘inside’ information or ‘tips’.  The longer I operated in Wall Street the more distrustful I became of tips and ‘inside’ information of every kind. Given time, I believe that inside information can break the Bank of England or the United States Treasury.  A man with no special pipeline of information will study the economic facts of a situation and will act coldly on that basis. Give the same man inside information and he feels himself so much smarter than other people that he will disregard the most evident facts.” Perhaps there should be something called a “stock tip” heuristic/bias. People who get a stock tip will often suspend disbelief and stop being rational. It is best to “just say no” to stock tips.
  1. “Mankind has always sought to substitute energy for reason, as if running faster will give one a better sense of direction.” Baruch is pointing out that there is no prize for hyperactive trading in markets. There is in fact a penalty in the form of fees, costs and taxes. If stock prices drop some people think they can fix that with more activity when often leads to mistakes,
  1. “Always keep a good part of your capital in a cash reserve. Never invest all of your funds.” Cash is like financial Valium. Cash can keep an investor calm and more importantly given them the ability to buy a bargain when it becomes available.
  1. “The wisest course is to sell to the point where one stops worrying.” “Learn how to take your losses quickly and cleanly. Don’t expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.” Buffett makes the point that if your stock holdings make it hard for you to sleep you should be holding a greater percentage of less volatile assets in your portfolio like cash and bonds. Having said that he also says: “Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
  1. “In the stock market one quickly learns how important it is to act swiftly.” Markets are not perfectly efficient, but they are mostly efficient. Bargains that you can spot within your circle of competence don’t come along that often and when they do you must be ready to pounce sinnce the bargains won’t be available for long. You must be patient and yet brave enough to act quickly and aggressively when an opportunity presents itself.
  1. “Nobody ever lost money taking a profit.” “It is one thing to make money and another thing to keep it. In fact, making money is often easier than keeping it.” There is an old saying that you can make a profit as a bull or bear but never a pig. Baruch is also saying once you take a profit it can be hard not to spend it.  The more you spend the more you feel pressure to push the edge of the envelope which can lead to mistakes. I’ve never found that more expensive stuff makes you any happier.

 

Notes:

A Decade of Delusions:  http://www.amazon.com/Decade-Delusions-Speculative-Contagion-Recession/dp/1118004566/ref=sr_1_1?s=books&ie=UTF8&qid=1456343773&sr=1-1&keywords=a+decade+of+delusions

Bernard Baruch, My Own Story: http://www.amazon.com/Baruch-My-Own-Story-Bernard/dp/156849095X

Josh Brown on Baruch: http://thereformedbroker.com/2013/02/17/bernard-baruchs-10-rules-of-investing/

Investopedia: http://www.investopedia.com/ask/answers/032715/who-were-bernard-baruchs-greatest-influencers.asp

Wikipedia: https://en.wikipedia.org/wiki/Bernard_Baruch

The Dictionary of American Biography:  http://www.sunnycv.com/steve/ar/d7/baruch.html

Bernard Baruch: Adventures of a Wall Street Legend (Jim Grant):  http://www.amazon.com/Bernard-Baruch-Adventures-Street-Legend/dp/1604190663

 

 

 

 

A Dozen Times Mark Twain and Warren Buffett have said Similar Things

My objective in this blog post is to contrast the investing outcomes of an amateur investor like Samuel Clemens (Mark Twain) with the outcomes experienced by a professional investor. One type of investment where most anyone can see this difference is in venture capital, where Twain was quite active over the years even though the word had not yet been created. His performance as a venture capital investor was terrible. Why? Well, as Warren Buffett says, “risk comes from not knowing what you are doing” and Twain was often involved in businesses and investments he knew next to nothing about.

That so many people seem to think business and investing are easy is a bit of a paradox. What is simple is not necessarily easy. To illustrate, seven professional venture capital investors would never say: “Let’s perform a colonoscopy on Fred.” Well, they might if they hated Fred, but that is a special case. And yet seven doctors may say: “Let’s make this venture capital investment” without a professional lead investor also being involved in the business so they can sit in a sidecar. As I wrote in my post last weekend about the professional seed round investor Steve Anderson, it takes years to become a successful venture capital investor. Attending medical, law or pharmacy school and having a high IQ is not enough to make you a successful venture investor. There are many posts on this blog which discuss why success in venture capital requires much more than writing a check so I will not repeat that here.

Are amateur Angel investors much more likely to successfully sit in a “sidecar” when a professional venture investor is involved? Sure. As an example, in the Amazon seed round there were a few wealthy Angels involved, but there were also professionals investors participating in the round like Nick Hanauer and Tom Alberg. It is rare for an amateur Angel investor to get access to high quality seed investment opportunities like Amazon but it is surely a better alternative than investing in a startup along with with two dentists, a hardware store owner, a sociologist and a probate lawyer. How often are seed sound investments successful? I discussed that last weekend. I think the answer depends on how much you swing for the fences. Jason Calacanis said 8 of 10 of his investments are complete zeros in terms of return on capital but I suspect he is swinging harder for the 100X  return than many Angels. But many people will say that 4-6 of ten seed round bets will be a total loss.

Andy Rachleff is probably the most negative person I have read on amateur Angel investing. For example, he’s written an article entitled: “Why Angel’s Don’t Make Money… And Advice for People who are Going to Do it Anyway” that I link to in the notes. How many venture investors are out there investing today who are modern day Mark Twain equivalents? It is impossible to know for sure. There is no central database of Angels. Investors at seed stage are not required to register with anyone or report results to any government agencies. Some people, including a few academics, claim to have surveyed Angels on their investing returns to obtain useful data, but this process is like asking fishing enthusiasts about the quality and size of their catch. There are lots of psychological reasons people forget about unfortunate investing results and overly enhance any successes. If someone cites an academic study on the financial returns of Angel investors, look closely at where they obtained their data and how. Self-reported data from Angels obtained as part of a survey is simply not credible. With professional venture investors who have limited partners who must file reports with government agencies, at least there is a statute or regulations requiring that the filings are accurate. The existence of this data for professional venture capitalists allows information providers like PitchBook to produce statistics on venture capital returns that are accurate and therefore useful. In contrast, there is little accurate data on amateur Angel investing returns. What is the average aggregate return of an average amateur Angel investor? The answer is: no one really knows. There are limited partners of professional Micro VCs who know what their financial returns are, but as far as I know no one has revealed those results.

That Mark Twain made loads of different mistakes in his business investments is well documented. Why does someone like Buffett learn from his mistakes and Twain never seemed to do so?  Will Rogers pointed to part of the answer when he said: “There are three kinds of men. Some learn by reading. Some learn by observation. The rest of them must pee on the electric fence for themselves.”  But the main driver is what Charlie Munger describes here: “Warren and I aren’t prodigies. We can’t play chess blindfolded or be concert pianists. But the results are prodigious, because we have a temperamental advantage that more than compensates for a lack of IQ points.” As the just concluded Berkshire meeting  Munger said  that some of success is nature and some is nurture, and the precise ratio varies in each case. He believes that having the right judgment and temperament for investing is mostly innate.

How lousy were Twain’s investing results? The biographer Richard Zacks wrote this summary of Twain’s business follies:

“Mark Twain was a great author—but a stupendously incompetent businessman. He lost money on an engraving process, on a magnetic telegraph, on a steam pulley, on the Fredonia Watch Company, on railroad stocks. He once turned down a chance to buy into Bell Telephone even though he had one of the nation’s first residential phones. The author eventually lost so much money that in 1891 he moved the family out of their Hartford home; Twain would sell it after twenty years for about one-sixth the amount he put into it…. [Twain] poured thousands of dollars into backing a protein powder called Plasmon, which he claimed delivered 16 times the nutritional value of steak at a cost of a penny a day; it could ‘end the famine in India.’  Plasmon was the subject of a fraud trial in 1907, in which Twain tried to recoup his $30,000 investment (about $750,000 today). At the trial, Twain said that company president Henry A. Butters should have been paid “$3 a century” and was a ‘stallion in intention, a eunuch in action.’ Twain was asked if this was the first time that he had been swindled. ‘No, I have been swindled out of more money than there is on the planet,’ he told the judge.”

The Fredonia Watch Company sounds like it was part of a Marx brothers movie. The promoters of the watchmaking scam that Twain fell for were professional sellers of patent medicine. Why was Twain such an easy mark?  Some people have the idea in their head that the way to get ahead is to get rich quick with one big score. twain may have picked up  this attitude from his father who was  a land speculator. This approach usually leads to very painful outcomes. Twain admitted more than once that he was a born speculator. His most famous folly was:

“a new invention called the Paige Compositor.The machine was the brainchild of James Paige, a mechanic and inventor whose goal was essentially to transform the printing press (a machine that required a skilled professional to slowly prepare words to be set onto paper) to something more automatic, closer to a typewriter. Something that could print and align words quickly and cheaply.… By the time the compositor was finally completed in 1889, Twain had sunk the equivalent of $3 million in today’s currency. It wasn’t the first time he’d made a bad investment. Twain once threw money towards a project to create a hand grenade that could extinguish fires.”

 

 

 

 

 

 

 

According to the biographer Peter Krass, Twain was an incurable speculator and at one point stopped working on Huckleberry Finn to devote time to inventing a children’s trivia game.  His other inventions included a clamp to prevent infants from kicking the sheets off their beds  and a self-adhesive scrapbook.

 

If good judgement can be derived from bad judgement, Twain should have had plenty of material to learn from. Unfortunately, the lessons did not seen to stick in the case of Twain who repeatedly repeated mistakes.  A person like Buffett learns while another person like Twain does not. How is it that someone like Twain can say and write things that are sound and seem full of wisdom and yet ignore that advice in their own decision making? How can his ability to observe human nature be so good and yet his decision making in business be so bad? The failure of someone to heed their own advice is not a new problem since proverbs like: “The cobbler’s children are always the worst-shod” or “Physician heal thyself” are very old.

One theory is that Twain’s painful business experiences made him a better writer. Twain’s business losses were perhaps literature’s gain. Stanford English professor Shelley Fisher Fishkin believes:

“It would be fair to say that he probably would not have necessarily decided to earn his living as a writer unless he had failed as a silver miner. He learned things from all of his experiences and adventures that came in handy when he wrote.”

A secondary objective of this blog post is to remind people of a few of Buffett’s more important ideas. Each Twain quote is paired with a Buffett quote for that reason.  Twain often managed to get the advice right in terms of what he said or wrote, but had a hard time following his own instructions.

Before getting to the customary dozen quotes, here’s a Tom Sawyer style story from Alice Schroeder’s Warren Buffett biography Snowball that illustrates how he is similar to Mark Twain’s most famous character in some ways:

 

“Doing what he called his Tom Sawyer routine, Warren said to Kerlin: ‘This is your chance. We’re going to deal you in.’ We told him that we would go out at four in the morning to some golf course in Virginia, and that he would wear the gas mask in the lake and retrieve the balls, and we’d split the money three ways. “Kerlin said, ‘How do I stay down on the bottom?’ I said, ‘Oh, I’ve got that all worked out. What we will do is, you’ll strip, and you’ll be nude, but you’ll wear my Washington Post newspaper bag, and we’ll put barbell plates in the newspaper bag so that you’ll stay on the bottom.’ “So we got out there at the crack of dawn. Kerlin was stripped, and we were dressed warmly. He was totally nude with a Washington Post newspaper bag on and all these barbell plates, and he started wading into the lake. Of course, he didn’t know if he was stepping on snakes or golf balls or whatever. And then he got down and when he tugged on the rope, we pulled him back up. He said, ‘I can’t see anything.’ We said, ‘Don’t worry about seeing anything, just grope around.’ And he started to go back down. “But before his head went under, this truck came over the rise, carrying the guy that’s going to fill up sand traps in the morning. He saw us and drove up, saying, ‘What are you kids doing?’ Danly and I were thinking fast. ‘We’re conducting an experiment for our high school physics class, sir.’ Kerlin was nodding the whole time. So we had to get him out of the pond. The whole thing blew up on us.”

                                             

  1. Twain: “There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” “OCTOBER: This is one of the peculiarly dangerous months to speculate in stocks in. The other are July, January, September, April, November, May, March, June, December, August, and February.”  Following the Equator, Pudd’nhead Wilson’s New Calendar. 

Buffett: “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”So there’s two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm. And then there’s assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn’t produce anything. And those are two different games. I regard the second game as speculation.”

  1. Twain: “Behold the fool saith, ‘Put not all thine eggs in the one basket’ — which is but a manner of saying, ‘Scatter your money and your attention;’ but the wise man saith, ‘Put all your eggs in the one basket and –WATCH THAT BASKET.’” Pudd’nHead Wilson‘s Calender

Buffett: “We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury.’” “[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when “dumb” money acknowledges its limitations, it ceases to be dumb.”

 

  1. Twain: “Whenever you find yourself on the side of the majority, it is time to reform (or pause and reflect).” Notebook, 1904

Buffett: “You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.”

 

  1. Twain: “All my life I have stumbled upon lucky chances of large size, and whenever they were wasted it was because of my own stupidity and carelessness.”  Letter to Mr. Rogers

Buffett: “During 2008 I did some dumb things in investments… I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.”

 

  1. Twain: “A man who goes around with a prophecy-gun ought never to get discouraged: if he will keep up his heart and fire at everything he sees, he is bound to hit something by and by.”  Autobiography of Mark Twain

Buffett: “I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”  ‘Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” “I don’t read economic forecasts. I don’t read the funny papers.”

 

  1. Twain: “Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark: ‘I wasn’t worth a cent two years ago, and now I owe two millions of dollars.’” The Gilded Age

Buffett: “When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”

 

  1. Twain: “Money and chips are flung upon the table, and the game seems to consist in the croupier’s reaching for these things with a flexible oar, and raking them home. It appeared to be a rational enough game for him, and if I could have borrowed his oar I would have stayed, but I didn’t see where the entertainment of the others came in. This was because I saw without perceiving, and observed without understanding.” Aix, Paradise of Rheumatics

Buffett: “On my honeymoon I traveled out west. When I visited the casino and saw all these smart well-dressed people participating in a game with the odds against them, it was then that I realized I won’t have a problem getting rich!”

 

  1. Twain: “The lottery is a government institution & the poor its best patrons.” Notebook #17, October 1878 – February 1879

Buffett:  “I get dozens of letters, almost daily from people who have financial difficulties for one reason or another. And they overwhelmingly come from three sources: One is health problems, people run into unexpected medical bills and it gets them into a tough situation. Second, they get into trouble on credit cards, frequently and a credit card is a temptation to many people. But the third thing I hear about is people who have an addiction to gambling. And they’ve used thousands and thousands or tens of thousands of dollars that the family needs and they just can’t get off the hook and they find themselves in enormous financial trouble, sometimes that interacts with the credit card situation.” “I think that for a state to essentially prey upon its citizens, create more of these addictions, create more of these letters coming in every day, I just think it’s wrong. I think it’s cynical on the part of the state to raise money from people who basically can’t afford it by promising them a dream that is not going to come true.” “There’s nothing getting developed. It’s a transfer of money. I mean, basically, if you take the losses of everybody who participates in gambling, (it’s not gaming, it’s gambling), if you take the losses, it goes three places: it will end up going to the state as taxes, to some degree, that’s not development. It will end up paying part of the operating expenses, but any place you spend money with will pay expenses of that establishment. And it will go to the owners.” “Addictions produce crime. If you have a large group of people that are addicted to drugs, you are going to have more crime. If you have a large group of people that are addicted to gambling, you are going to have more crime. People get into impossible situations when they get into positions like that.” “For every lucky person, there’s hundreds of thousands, you just keep feeding the kitty and in the end, it’s just a big loser for everyone.” “It is certainly clear that a given percentage of people will become addicted and use money they’ve got no business using and that percentage is not a small percentage.” “You’re teaching your citizens something all the time by the actions you take as legislators and as administrators of a state like this [Nebraska]. And essentially they teach you that the state is on the other side of the transaction from you, they’re trying to get you to do something dumb. I think the state ought to be trying to do something for its citizens, not do something to its citizens.”

 

  1. Twain: “The mind exercises a powerful influence over the body. From the beginning of time, the sorcerer, the interpreter of dreams, the fortune-teller, the charlatan, the quack, the wild medicine-man, the educated physician, the mesmerist, and the hypnotist have made use of the client’s imagination to help them in their work. They have all recognized the potency and availability of that force.” Christian Science

 

Buffett: “Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: ‘The fault, dear Brutus, is not in our stars, but in ourselves.’”

 

  1. Twain: “Being rich ain’t what it’s cracked up to be. It’s just worry and worry, and sweat and sweat, and a-wishing you was dead all the time.” The Adventures of Tom Sawyer

 

Buffett: “Success is getting what you want. Happiness is wanting what you get.”

 

  1. Twain: “It isn’t the sum you get, it’s how much you can buy with it, that’s the important thing; and it’s that that tells whether your wages are high in fact or only high in name.” A Connecticut Yankee in King Arthur’s Court

 

Buffett: “The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a five per cent passbook account whether she pays 100 per cent income tax on her interest income during a period of zero inflation or pays no income taxes during years of five per cent inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 per cent income tax but doesn’t seem to notice that five per cent inflation is the economic equivalent.”

  1. Twain: “He had discovered a great law of human action, without knowing it–namely, in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.” The Adventures of Tom Sawyer

 

Buffett: “Charlie said of the seven deadly sins, envy is the worst. You feel miserable-but the other guy has no idea how you’re feeling. Envy-where the hell is the upside?”

Notes:

Twain Quotes: http://www.twainquotes.com/Luck.html

Alice Schroeder, Snowball  http://www.amazon.com/The-Snowball-Warren-Buffett-Business/dp/0553384619

The only film footage of Twain   http://www.openculture.com/2014/09/the-only-footage-of-mark-twain-the-original-digitally-restored-films.html

Richard Zacks essay on Twain as an investor:  http://time.com/4297572/mark-twain-bad-business/

Peter Krass book: “Ignorance, Confidence and Filthy Rich Friends: The Business Adventures of Mark Twain, Chronic Speculator and Entrepreneur.” http://www.reuters.com/article/us-books-twain-idUSN0923316520070316

Andy Rachleff: Why Angel’s Don’t Make Money… And Advice for People who are Going to Do it Anyway.  http://techcrunch.com/2012/09/30/why-angel-investors-dont-make-money-and-advice-for-people-who-are-going-to-become-angels-anyway/

Seth Fiegerman: https://openinglines.org/2009/11/26/the-paige-compositor-mark-twains-terrible-invention/

A Dozen Things I have learned from Steve Anderson About Business and Investing

 

Steve Anderson is the founder of the pioneering “micro VC” Baseline Ventures. What is a micro VC?  As the name implies, micro-VCs are smaller versions of more traditional venture firms (e.g., they raise less money and invest smaller amounts at an earlier stage in life cycle of the startup business). Mattermark writes about the category: “Most (around 80 percent) of the initial investments that micro VC firms make are in companies that are at the seed stage, whereas traditional VCs tend to focus on later or across multiple stages.”

Anderson raised his first $10 million fund in 2006 and most recently raised a $100 million fund in just four weeks. Before entering the venture capital business, Anderson worked at eBay, Microsoft, Kleiner Perkins, Starbucks and Digital Equipment Corporation. Baseline Ventures has invested in more than 75 businesses and generated more than 25 financial exits. Among the more famous Baseline Ventures investments are its early investments in Instagram and Twitter.

Venture capital is obviously itself a business and innovations like micro VC (e.g., Baseline), platform (e.g., a16z), compensation and governance (e.g., Benchmark) happen. As examples of this phenomenon, I recently wrote about two other innovators: Jessica Livingston who was a co-founder of Y Combinator and Chamath Palihapitiya who plans to transform his business into something that looks similar to Berkshire.

Here are the customary dozen quotations:

 

  1. “In 2006 I was starting to ruminate on the idea of founding a company. When I began to think about raising seed capital there were few alternatives to consider.” “The average exit over the last ten years on average has been $100 million. If I own 10% of a $100 million outcome that is real money for me and my co-founders.  Why isn’t anyone [in venture capital] aligned for that sort of outcome?” There is an informative video on YouTube in which Chris Dixon and Anderson talk about how early in their careers they each wanted to finance their own businesses and found themselves faced with a requirement that they sell more than half of the equity in the business just at seed stage to get the cash they needed.  In an email to me, Chris Dixon described the situation he encountered then in this way:

 

“When I started my first VC-backed company in 2004 there were 10-20 firms who might consider investing in consumer internet companies, and they were all bigger VC funds that were designed to invest in Series A or later. In our seed round we had to give up >50% of the company for 2.6M (plus the deal was tranched which added other challenges). It was pretty obvious that the market needed a new product. I ended up co-founding my own seed fund (Founder Collective) and investing in Baseline, Lowercase, and a few other people who saw the same opportunity.”

 

What most experienced founders want at seed stage is a lead professional investor who can add more than just capital to the business (for example, a range of startup experience and company building skills). What do I mean by professional investor? In my dozen things profile of Keith Rabois I quote him as saying: “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.” Professional investors are more than just wealthy and well-connected. They can add the benefits of their networks and business skills to the businesses they invest in. It is common to have non professional Angel investors in a seed round. But it is generally not optimal to have no professional investor involved in a seed round. I again agree with Keith Rabois: “If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.” Exclusively raising funds in the form of $25K to $50K checks from a long list of nonprofessional investors like florists and dentists is not optimal.  Some seed round can become what Tom Tunguz recently described: “Party rounds symbolized the heyday of the startup seed market just last year. Called parties because of the number of investors who collaboratively financed seed rounds of startups, the lists became almost comically long as seed sizes ballooned and investor syndicates swelled with them.”

Fast forward to today from the period of time when Steve Anderson and Chris Dixon were both having a hard time raising funds for their startups without massive dilution and there are more seed stage venture capitalists (374 at last count) offering much more attractive terms, assistance and valuations to founders. The investment climate now in micro VC is robust according to data provided by my friends at PitchBook:

 PBB

Data on angel and seed rounds more generally can be seen here:

 

Angel.Seed%20Activity

  1. “You have to sell at least 20% of your company at every financing [if it’s a big venture fund involved since they need to put a lot of money to work to justify the deal].” Traditional venture capital firms can only sit on so many boards and help only so many startups at any given time. They have a high opportunity cost and in many cases can’t invest without taking a significant equity stake. It should be noted that not every business is right for  venture capital. Many businesses should not raise venture capital at all and are better off trying to financially bootstrap. Fred Wilson has a post on how he invests in “media, food products, restaurants, music, local real estate, local businesses” which he explains in the form of an example: “…the investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14% and the total multiple is 1.3x.”

 

  1. On average I invest $500k.” If you raise a $100 million fund you can obviously make a lot of seed stage investments. There is not precise formula for how the funds are allocated in any given fund. How much a given seed stage venture capital firm saves for follow on investments varies from firm to firm and from year to year. Mattermark’s data says 20% of investments of micro VC investors are non-seed stage. In general, data from Tom Tunguz says there are less party rounds right now which is a good thing for founders and investors:

share_of_dollars_by_party_size

 

  1. “Ten years ago you needed $5 million to start [a business]. Today you need $70 and some coding skills.”  One thing that is remarkable about raising funds at seed stage for a business today is now little cash it takes to fund the company relative to the past. Access to cloud services and modern software development methodology means you need less money and people to create a business than ever before. This lowering of capital requirements is good and bad: good in that it enables people to get ideas to market more effectively and quickly, but bad in that enables a lot of poseurs to flood the market. which often sends confusing signals. Too much money delivered too early into a market is not helpful if you are a founder trying to create a successful business. The best founders do better when there is less noise and more signal in the investing and business environments.

 

  1. “Generally speaking, most of my investments are pre product launch- they’re just an idea.” There is so much uncertainty and ignorance involved in seed stage investing that a focus on factors like the strength of the team becomes extra important since what an investor is trying to purchase at a bargain is optionality. Investable ideas at seed stage are not easy to find, but the ability to actually execute on those ideas and iterative to adapt at the environment evolves is even harder to find. Most businesses which take a seed stage investment fail. Jason Calacanis wrote this past week: “Startups before their A round — which is where I operate — are a high mortality business. Eight of 10 startups angels invest in, in my experience, are a donut (zero dollars returned).” Not everyone will have the same failure rate as Jason since everyone has a different propensity to take on bets with bigger potential upside, but a higher failure rate. As was stated above, there are no precise formulas in venture capital and investing and business conditions change over time. But there are certainly tendencies that experienced venture capitalists can use to their advantage. As a wise person once said, the past does not repeat itself precisely, but certain things tend to rhyme over the years.

 

  1. “Your goal is product market fit.” “My goal as an investor is to make sure there’s enough financing to give companies time to do that, a year to 18 months. The worst scenario is to try to raise more money when you haven’t achieved that goal.” “If you don’t have it, eventually you’ll run out of cash, say the experiment is wrong, and fold up your tent … A lot comes down to the entrepreneur. Do you keep doing this against all the feedback, or not? That’s why when I invest I want to leave enough room for pivoting or reexamining your goals. After that, most of the time entrepreneurs are realistic near the end and say this isn’t working. Those decisions aren’t that difficult. It gets more difficult in later stages when you’ve got millions of dollars in. Usually there, you try to sell the company.” Too much money can distract a young business from focusing on what is necessary to create a successful company. Businesses don’t just die from starvation- they can just as easily die from indigestion. And they often do. Ironically, many investors believe the best time to start a business is in lean times. The root cause of a business running out of cash is often that the business lost focus and diverted resources to activities not on the critical path toward success.  Cash starvation or indigestion is often a symptom of bad decisions like premature scaling, trying to do too many things at once or pivoting too often.

 

  1. “With series A, B, C, or growth investments, you already know what you want to invest in.” Investing in a business before “product market fit” exists means decisions are relatively more instinct-based since the investor has less data. Anderson has even said in an interview that he tends to go with his gut on his seed investments. My blog posts on Eric Ries and Steve Blank set out their thoughts on finding product market fit.  Andy Rachleff describes the process well: “Eric [Ries and I] believe in order to increase the likelihood of succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The value hypothesis should state the founder’s best guess as to what value will drive customers to adopt her product and indicate which customers the product is most relevant to, as well as what business model should be used to deliver the product. It’s highly unlikely that a founder’s initial hypothesis will prove correct, which is why an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is achieved. As a consumer company, you know you have proved your value hypothesis if your business grows organically at a rapid pace with no marketing spend. Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders mistakenly pursue their growth hypothesis before their value hypothesis.”

 

  1. “It’s all about networks. I spend time with entrepreneurs, I meet them mostly through other entrepreneurs.” Success begets success. Cumulative advantage is a underappreciated factor that drives the success of any business. For a venture capitalist, investing at the seed stage is a hustle game. By that I means not only the ways in which these investors help portfolio companies but also the ways in which they acquire deal flow and contacts. Reaching out and helping people in advance pays big dividends. Everyone has mentors on how to do things and mine was a wonderful fellow named Keith Grinstein. Pound for pound Keith was the greatest networker I have ever seen. No one even comes close. To illustrate how good he was at networking, when he passed away far too young most everyone at the funeral considered him their best friend.

 

  1. “You will know if you like [venture capital] well before you know if you are any good at it. “It takes five, six, seven, eight years… the cycles of feedback are long, which is difficult. Becoming a great venture capitalist can take as long as seven to ten years to get right. Sometimes you make a mistake as an investor and don’t pay the price for many years. The long learning curve in venture capital is not only hard but impossible to eliminate unfortunately. Every venture capitalist is to some extent paying the equivalent of tuition every time they invest in a business.  Investments made early in the career of a venture capitalist tend to be more “tuition heavy” than the investments they make later in their career.

 

  1. “There is a robust seed market now.” “Returns dictate everything. If the asset class has the financial returns, more money is going to come.” There are roughly 375 micro VC firms in the United States. The jury is still out on the right number of micro VCs since the category is so new and surely that number will vary over time as conditions change.  A significant constraint on industry size is the overall level of financial exits for portfolio companies. When micro VCs collectively put X dollars of capital to work they must eventually generate enough financial  exits for their investors or they will not invest enough to keep the category healthy. In other words, venture capital in the medium and long-term is top-down constrained by the aggregate level of financial exits for portfolio companies.Venture capital has been and is likely to always be a cyclical business. In the seed investing category, the presence of angel investors clouds the picture even further.  It is impossible to quantify with any degree of certainty how many Angels are making seed investments at any point in time or their financial returns. People try to quantify the financial returns on Angel investing but there is huge survivor bias and lots of storytelling involved. One relatively recent guess is: “about 300,000 people have made an angel investment in the last two years.” Another guess: “A total of 29,500 entrepreneurial ventures received angel funding in Q1 of 2015.”

 

  1. “[Accelerators were created] for people who don’t have their own networks or can’t grow their networks. How often do you show up to one place and see 80 companies? Of course with that scenario you’ll pay a higher price because more people are looking. That’s fine. Entrepreneurs have more transparency today than ever before, they can choose the types of investors they want to work with.” It’s great that investors and founders today have so many choices, including participating in accelerators. The more transparent the choices are for founders the better off everyone is. My recent post on Jessica Livingston discusses the benefits of accelerators for founders.

 

  1. “In this business you will have a long list of things you could have done. If I miss something, I try to learn from that.” Every venture capitalist has investments that they pass on which represent missed opportunities. That is the nature of the business. The important thing is not whether you make mistakes (because you always will to some extent) but whether you learn from your mistakes. I have heard Bill Gurley and Bruce Dunleive of Benchmark Capital say more than once over the years: “Good judgment comes from experience, which comes from bad judgment.”  Absent the direct lesson that comes from making a mistake yourself, reading about other people who do things and fail or succeed can also be helpful, especially if it allows you to avoid “peeing on the electric fence” yourself.

 

Notes:

Business insider: http://www.businessinsider.com/steve-anderson-baseline-ventures-instagrams-first-investor-explains-what-he-looks-for-in-companies-2012-4

TechCrunch: http://techcrunch.com/2011/10/25/founder-stories-baseline-ventures-steve-anderson-on-why-he-invested-in-heroku-and-weebly/

YouTube interview: https://www.youtube.com/watch?v=Z0AWCLGk8ow

Micro VC: http://500.co/micro-vc-rising-analyzing-trends-and-the-top-investors-in-the-micro-vc-ecosystem/

Fred Wilson:  http://avc.com/2010/01/how-to-calculate-a-return-on-investment/

Angel Capital Association:  http://www.angelcapitalassociation.org/faqs/

Pitchbook:   https://pitchbook.com/   

Pitchbook charts: http://pitchbook.com/news/articles/the-state-of-the-us-venture-industry-in-7-charts?linkId=23570714

Tom Tunguz:  http://tomtunguz.com/party-in-seed-rounds/

Mattermark:   https://mattermark.com/

Eric Ries post:   https://25iq.com/2014/09/28/a-dozen-things-ive-learned-from-eric-ries-about-lean-startups-lattice-of-mental-models-in-vc/

Steve Blank post: https://25iq.com/2014/10/18/a-dozen-things-ive-learned-from-steve-blank-about-startups/

Andy Rachleff: https://blog.wealthfront.com/venture-capital-economics-part-2/

Center for Venture Research  https://paulcollege.unh.edu/sites/paulcollege.unh.edu/files/webform/Q1Q2%202015%20Analysis%20Report%20FINAL.pdf

Calacanis:  http://calacanis.com/2016/04/21/lions-lambs-in-the-post-unicorn-era/

 

 

 

A Dozen Things I’ve Learned from Mary Meeker about Investing

 

Mary Meeker is a partner at the venture capital firm Kleiner Perkins Caufield & Byers. Before becoming a venture capitalist she was a Managing Director, Research Analyst, and Technology Analyst at Morgan Stanley from 1991 to 2010. She previously worked at Salomon Brothers. Meeker received her MBA from Cornell.

Meeker and I lived through many of the same events, but in different places, which creates different perspectives. For example, Meeker said once: “I bought my first PC in 1981.”  I bought mine around the same time (an Apple II). We both lived through the rise and fall of the Internet bubble in the 1990s. If you lived through that bubble as a participant, it changed you. Experiences as vivid and intense as the Internet bubble give you fundamentally different muscle memory about finance and the business world. Some people became rich on paper in just months and the impact of that was that envy and jealousy which caused some people to lose their tie to reality. The environment was literally nuts. Fear of missing out made people do things that in retrospect seem insane.

When I said that I was going to write this post on Meeker a few people said to me: “I lost money based on her recommendations in 2000.” I am not going to comment much on that set of issues in this post since Meeker makes her own case in a well-known Newsweek interview. http://www.prnewswire.com/news-releases/newsweek-interview-mary-meeker-morgan-stanley-stock-analyst-71696332.html  I will say that the business model for sell-side research is problematic since few people (if any) are willing to pay for the work.  This creates a free-rider problem and other issues. Meeker is no doubt much happier on the buy-side.

Now for the usual dozen quotations:

  1. “In a typical year, there are generally two technology companies that go public and become 10-baggers, which means they deliver a 10-times return on investment. We were trying to find those two companies.” This statement by Meeker reflects a fundamental truth about the venture capital business. There are firms like 500 Startups which  are following a different venture capital model (see my blog post on Dave McClure) but what Meeker describes is the dominant model. The traditional venture business is all about the Babe Ruth effect (it is magnitude of success and not frequency of success that matters). Fred Wilson just wrote a post in which he explained that his firm loses all of its money in over 40% of its venture investments. This is normal and an essential part of the traditional venture capital business. The number of times something like Facebook can happen in the global economy is top down constrained by a number of factors including addressable market. It is simply not possible to have even a tiny number of Facebook style financial outcomes every few years.

 

  1. “The race is won by those that build platforms and drive free cash flow over the long-term (a decade or more). That was my view in 1990, 1995, 2000, 2005, 2010, and it remains the same today.” The grand-slam tape-measure home run financial wins that venture capitalists like Meeker seek are most often found in the form of multi-sided markets or platforms. To generate big returns you need a business that scales amazingly well and nothing scales better than software delivered as a service that creates a platform business. You also need a moat and that can sometimes, with a lot of effort and luck, be created through network effects. When a platform is created in the right way it has almost zero marginal cost to deliver the service and thus very attractive margins.

 

  1. “I [read] an article in the New York Times written by John Markoff about Jim Clark going to the University of Illinois at Urbana-Champaign to invest in a Web browser company called Mosaic Communications run by Marc Andreessen. It was one of those moments. I picked up the paper and said: That’s it. This was 1994. Morgan Stanley then raised money for Mosaic – I actually have that business plan somewhere. The company promised to ‘change the way the publishing world works.’” At the time Mary Meeker describes in the previous sentences I was working for Craig McCaw who is a good friend of Jim Clark.  And Jim Barksdale, who was running McCaw Cellular at that time, would leave to be CEO of Netscape in 1995. So we were very curious about what was going on at Netscape. Craig McCaw sent me and a colleague down from Seattle to visit Netscape to see what Netscape was doing. We were impressed by the products but also the intensity of the battles with Microsoft at the time. Meeker was right that at tat time in history it seemed like liftoff was imminent. By 1995 the launch parties were getting bigger, spending more lavish and the stakes higher. Capital was starting to flood into the technology sector. In one sense, we were all frogs in a pot of water that was steadily getting hotter. People who spout off and say “I would have know what was happening” are fooling themselves. Things were euphoric enough in the markets in 1998-2001 that even the smartest people did dumb things.

 

  1. “It is one thing to be wrong about the valuation and the timing. It’s another thing to be wrong about the business model.”  I addressed what a business model is in my posts on Steve Blank and Eric Ries. I like the definition used by Mike Maples, Jr.: “The way that a business converts innovation into economic value.” Steve Blank has his own definition: “A business model describes how your company creates, delivers and captures value.” If a startup can’t create, deliver and just as importantly capture economic value, it is going to fail.  A business needs core product value, a scalable delivery system and a moat to protect itself from competitors. Just one or two is not enough. A winning business must achieve all three. In looking at issue like the business model it is possible to make mistakes. If your mistake concerns having an unsound business model that mistake is usually fatal unless you can correct it before you run out of cash. Meeker is saying that valuation and timing are much more solvable problems.

 

  1. “In general, a good rule of thumb is that for an attacker to beat an incumbent, the attacker’s product typically needs to be 50% better, and 50% cheaper, and sustain that competitive advantage for a year or two, to be able to gain material market share.” There is a lot of inertia in the behavior of humans. Consumers don’t always rationally address decisions like what product to use or whether to stop using a product. People in general in the mass market want a margin of safety when asked to move to a new product. The greater the value differential the lower the cost required to move the mass market customer to a new product. For this reason the value that a challenger must deliver is ratcheted up. The greater the value differential between the new product and the incumbent’s product the lower the customer acquisition cost and the lower the cash that will be burned in getting the business to the critical mass and network effects in my post on that topic.

 

  1. “Technology stocks are volatile.”  JP Morgan once said the same thing about stocks generally: “The stock market will fluctuate.” And tech stocks can be especially volatile. The best way to deal with volatility is to remember that you can make it your friend. If stock prices were not volatile there would not be as many bargains. Remembering that risk is not the same thing as volatility, is very important.Why ate tech stock more volatile?  Risk, uncertainty and ignorance have been shown to increase when research and development is a high. This is common sense – when conditions impacting a business change more often due to changes in technology prices are going to be more volatile. If tech falls within your circle of competence it can be a great place to invest. Warren Buffett who feel that tech falls outside his circle of competence has said: “I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country’s standard of living to rise, and that’s clearly good. As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride.”

 

  1. “You never want to catch a falling knife.” A falling knife is a term used to describe the price of an asset that has fallen significantly over a short period, and has significant uncertainty about how much further it will fall. Because momentum and emotions are involved when a knife is falling the risk of mistiming the bottom is significant. Making accurate predictions about human behavior is, ahem, hard to do in a way that creates a significant margin of safety, especially after costs are deducted. It would be great if someone rung a bell when a knife hits bottom, but that never happens. Knives can continue to fall irrationally further down longer that you can remain solvent. If you stay focused on valuation relative to a benchmark like intrinsic value, you are far better off than you will be be trying to time markets. One way to avoid catching a falling knife is to have a margin of safety when buying assets. The idea is that with that margin of safety you can make mistakes or have bad luck and still do fairly well. Having a margin of safety when buying assets is like keeping a safe driving distance between you and a car ahead of you when driving at 70 MPH.

 

  1. “One of the greatest investments of our lifetime has been New York City real estate, and investors made the highest returns when they bought stuff during the 1970s and 1980s when people were getting mugged. The lesson is that you make the most money when you buy stuff that’s out of consensus.”  It is a mathematical fact that to outperform the market average results the investments must be contrarian in a way that is correct. Buying when other people are fearful can product great bargains. It can also produce great losses to. You must buy assets that are out of consensus and you must be right to outperform the market average. Many smart people have decided not to outperform market averages and instead buy a diversified portfolio of low cost index funds and ETFs.

 

  1. “Buy [technology stocks] when no one is interested in them. Sell when everyone is interested in technology (or when attendance at technology conferences reaches record levels or when your grandmother wants to buy a hot technology IPO).” This is of course a restatement of the Mr. Market metaphor that was the subject of the previous quote in number 8. Be greedy when others are fearful and be fearful when others are greedy.  But Meeker is making the additional point about the folly stocks tips. When the shoe shine operator at the airport or your Uber driver tells you what stocks you should buy, that is a “tell” that the market is overheated.

 

  1. “Don’t fall in love with technology companies. Remember to view them as investments.” This statement by Meeker is also a bedrock tenant of value investing. A share of stock is not a piece of paper to be traded but instead a partial interest in a real business that must be understood fundamentally to be properly valued. The business should be evaluated dispassionately based on sound data and analysis and only when it is within your circle of competence. There is significant danger is getting swept up in the madness of the crowd.

 

  1. “I’ve made my best personal investments when I’ve been a user of the product.” This statement has similarities to a famous statement by Peter Lynch:  “I’ve never said, ‘If you go to a mall, see a Starbucks and say it is good coffee, you should buy the stock.’” Lynch says: “People seem more comfortable investing in something about which they are entirely ignorant.” If you understand the steel industry deeply you are more likely to make better decisions about the steel industry. This is circle of competence thinking. Since risk comes from not knowing what you are doing, it best to be a real users of the product and even more importantly know that industry well. Meeker is famous for her long working hours, 200 slide presentations and extensive research.  Lynch also said once: “Investing without research is like playing stud poker and never looking at the cards.” You can’t understand a business and its place in an industry without doing research. And in doing research you must find something that the market does not properly discount into the price of the stock or bond.

 

  1. “I love data. I think it’s very important to get it right, and I think it’s good to question it.” The amount of data in Meeker’s massive slide decks is legendary. And of course she has more data than ends up in the side decks. Some of that data is  from companies talking their book and some not. She is saying in this sentence that you need to think carefully about any data to make sure it does not lead you to make a false conclusion. For example, it is easy to confuse correlation with causation. In thinking about any data it is best to avoid acting like the drunk who uses lamp posts for support rather that illumination. Sometimes the data you need is in a dark corner of the parking lot where there is no light. In that case you may need to put the decisions in the “too hard” pile.

 

Notes:

Wired:  http://www.wired.com/2012/09/mf-mary-meeker/

WSJ: http://blogs.wsj.com/moneybeat/2015/04/24/mary-meeker-where-is-she-now/

Forbes: http://www.forbes.com/sites/ericsavitz/2012/07/19/mary-meeker-talks-twitter-waze-venture-capital-and-more/#18712f48589c

Fortune: http://archive.fortune.com/magazines/fortune/fortune_archive/2001/05/14/302981/index.htm

Newsweek:  http://www.prnewswire.com/news-releases/newsweek-interview-mary-meeker-morgan-stanley-stock-analyst-71696332.html

Fred Wilson: http://avc.com/2016/04/losing-money/

 

A Dozen Things I’ve Learned from Jessica Livingston About Business and Investing

 

Jessica Livingston co-founded Y Combinator in March of 2005. The goal of Y Combinator is to provide seed funding for startups and help get the business to a point where they have “built something impressive enough to raise money on a larger scale.” The next goal is to “introduce the founders to later stage investors—or occasionally even acquirers.”

Livingston has written a book, “Founders at Work” (2007) based on interviews with startup founders including Steve Wozniak (Apple), Caterina Fake (Flickr), Mitch Kapor (Lotus), Max Levchin (PayPal), and Sabeer Bhatia (Hotmail). You can find my post on Y Combinator co-founder Paul Graham (and Livingston’s husband) as well as current Y Combinator President Sam Altman in the Notes.

Prior to co-founding Y Combinator, Livingston was vice president of marketing at Adams Harkness Financial Group. In addition to her work with startups at Y Combinator, she organizes Startup School. She has a BA in English from Bucknell.

 

  1. “I definitely think of Y Combinator as a startup in many ways. There are origin stories very similar to the way a startup would get started. We were kind of thinking about a problem, and thinking we could do some cool things to solve it.”“We started talking about the brokenness of the funding world in 2004 and it was.” The venture capital business is itself a business. There are many ways that the venture capital business has and will continue to evolve and innovate. Livingston is saying that Y Combinator’s evolution is an example of what a startup must go through to be successful. At the core of sustainable success for a business is always a real solution to a real customer problem. Livingston and the other co-founders of Y Combinator found 1) core product value, 2) a way to successfully deliver it to customers and 3) a significant barrier to entry against competitors from network effects and cumulative advantage. The manner in which firms like Sequoia, Y Combinator, Baseline Ventures, Benchmark Capital and Andreessen Horowitz operate in the venture capital business share elements in terms of the way they operate but also vary in significant ways. That is a good thing since diversity makes the system more resilient and productive. It is through experimentation and trial and error that new value is best discovered. Since most humans like to do what other humans are already doing progress requires that a few outliers exist who will try new things and harvest optionality. Why? Most people would rather fail conventionally, than succeed conventionally. Staying close to the warmth of the herd was a good strategy for most of human evolution. Fortunately, the evolutionary process produces enough oddballs that progress continues to happen. The great entrepreneurs I have worked with in my life are not normal people. They are oddballs in the best sense of the word. That is a very good thing. And no two of them are exactly alike.

 

  1. “Originally we were targeting programmers and wanted to teach them the business side of running a startup.” What Livingston describes is a noble calling. Huge value is locked up and lost to society when engineers with great ideas can’t bring them successfully to market. I have spent most of my professional life working with engineers who are sometimes challenged when it comes to business. I have seen the full spectrum from people who are business savants to engineers who know just about nothing and have zero desire to do so. The best business mind I have ever seen up close is Bill Gates. Gates ran the business side of the house at Microsoft from the time the business was first established in Albuquerque. He was the CFO and the CEO for many years. Contracts with customers were his responsibility. Gates was able to make these decisions intelligently because he grew up with a lawyer as a dad. His mom Mary was the smartest person in the family and was on many business and nonprofit boards. Mary was a genuine force of nature and would have loved to meet Livingston had she lived longer. It was incredibly fortunate that someone with scarce programming skills like Bill Gates also knew a lot about the law, business, and contracts. He learned these things at places like the dinner table with his mom, dad, two super smart sisters, his grandmother and the many guests who visited. Because of the many conversations that happened at this table and elsewhere Bill Gates understood the difference between a license and an outright sale in the early IBM negotiations which changed business history. Gates also sufficiently understood business, economics, and science that was needed to recognize the value of positive feedback and the likely rise of a new industry based on software. A young man with the right skills and knowledge took IBM in its prime to the cleaners. The types of things that Bill Gates learned at places like the dinner table when growing up, is what engineers learn at a place like Y Combinator. If you want to know a bit more about Mary Gates as a pioneering business leader read #12 in my post on Ann Winblad linked to in the Notes below. Anyone who knew Mary Gates knows that she was amazing.

 

  1. “What we wanted to do was create a standardized branded form of funding. Y Combinator wanted to be the ‘first gear’ for startups.” “We’re not expecting the money we invest to be the last a startup ever raises.  It’s just to get them going.  And we want to get as many startups going as we can.” Livingston is describing decisions that illustrate the power of focus in creating a valuable business. The founders of Y Combinator decided to focus on a specific problem many startups were facing. In the blog post I wrote on Ann Winblad I quote her as quoting Mary Gates: “Hey, it’s not about how fast you pedal, it’s about how clearly you focus.” The focus of Y Combinator not only creates specialized skills but enables the business to scale. Because of this focus and specialization other later stage venture capital firms view Y Combinator as a partner, which can create a self-reinforcing positive feedback loop which reinforces the moat.

 

  1. “Our motto is to make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.”What guided the founders through this process was their empathy for the users. They never lost sight of making things that people would want.”  The point Livingston is making is so obvious, and yet so often forgotten. If the customers is not having the “A-ha moment” in relation to a product the business will not be sustainably successful. Creating this value in new ways that have a barrier to entry is a rare thing. Creating systems that allow more businesses to do so is also a good. Any successful business like Y Combinator will have imitators and there are many. That is good for society but fortunately, success breeds success and a set of network effects creates enough of a barrier to entry that the business of Y Combinator is attractive.

 

  1. “At the time we were realizing, ‘Hey, it’s a lot cheaper to start a software company. I mean, all you need is a computer and to pay some of your server costs.’ So we thought, ‘Why don’t VCs write smaller checks?” And finally we said, ‘Let’s do something. Let’s create an investment company that does standardized branded funding. We’ll have an application process and this will be a new thing.’ But we always had thought that we’d do asynchronous investing just like every other investor. But then we said, ‘Neither of us know anything about angel investing. Let’s learn quickly by funding a bunch of startups at once.’” The idea of creating a system that runs startups through a synchronous process is efficient and logical. It reminds me of the many years I spent in school, especially in college and graduate school. There is no question that I learned more from my classmates than I did from my professors. As I interact with accelerators I see just this going on, with founders teaching each other in addition to learning from the program itself. Micro VCs are proliferating to a point where there are more than 350 in the US alone. This means more people are getting funded and that these people are more diverse in every sense. And founders are getting to keep a greater ownership stake in the businesses which increases the probability that the startup will survive the process. Founders who must sell 60 percent of their business at seed stage don’t have the same incentive to persevere in tough times. Cloud services substantially lowering the capital required to start a business also means that founders hold on to a larger stake as they go through the funding process.

 

  1. “Even Y Combinator got rejected at first. Nowadays there are a lot of groups that do the kind of investing we do, but when we started no one was. Even our own lawyers tried to talk us out of it.”[It’s] really important for people to remember was how often startup founders, that are hugely successful now, get rejected early on will say, “This is a dumb idea. You shouldn’t be working on that. No investor will invest in them.” “I mean, there are countless examples of people trying to raise funding and they just got turned down by investors because they thought it was a bad idea or didn’t think the person was formidable enough. That’s important because it’s hard to start a startup. If you’re a first time founder, you’re going to get rejected a lot in a lot of different ways, and it’s really hard.” Livingston is arguing that the non-consensus, contrarian view is powerful and significant. Howard Marks too argued that to earn more than the market return you must adopt a non-consensus view and that view must be sometimes correct in a significant way. This is all provable with mathematics. If you read even a few of the many posts in this series you see that same point made again and again in different ways. If your idea is not a little crazy then other people are very likely to be working on it. And there is unlikely to be undiscovered optionality which is what drives venture capital returns.

 

  1. “Perseverance is important because in a startup nothing goes according to plan. Founders live day to day with a sense of uncertainty, isolation, and sometimes lack of progress. Plus startups, by their nature, are doing new things, and when you do new things people often reject you.” “In general, your best weapon is determination. Even though we usually use one word for it, it’s actually two – Resilience and Drive. One reason you need resilience is that you’ll get rejected a lot. Everyone you encounter will have doubts about what you’re doing.” This drives home the point I have made repeatedly in this series of blog posts: missionaries are far more likely to survive than mercenaries. Steve Jobs said in 1995: “I’m convinced that about half of what separates successful entrepreneurs from the non-successful ones is pure perseverance.” Bill Gates has said similarly: “Perseverance has been characteristic of our great success.”

 

  1. “The media often glamorizes successful founders and makes their paths seem easier than they actually were.” “Just be determined, and have a little luck.” There is way more luck involved in life than people imagine. And yet the lucky have often gone through a not very glamorous crucible. You will hear people say sometimes that they worked hard to get lucky. The reality is that there is no way to increase your luck because anything you do to improve the probability of a positive outcome is skill. On luck, always read Michael Mauboussin. Then read him again. There is seldom a substitute for hard work and perseverance in the life cycle of a startup.

 

  1. “Starting a startup is a process of trial and error. “A lot of the startups in the book, and I see this again in Y Combinator startups, they start out saying, “We’re going to do this.” They try to do it and it doesn’t really stick, and so they think, “Oh, gosh. The users are actually more interested in this aspect of our site,” and they work on that. So there’s a lot of trial and error, and it gets glamorized, I think, in the press with these successful startups. They say, ‘Oh, he had this brilliant idea. We knew this was going to be big and it was great.’ That’s not the way it usually is. It’s usually a lot of testing one thing out, if not working, and then happening up on the right thing.” “People think startups grow out of some brilliant initial idea like a plant from a seed. But almost all the founders I interviewed changed their idea as they developed it.” I have written several posts on the importance and value of optionality for business and society. The first post is on the ideas of Nassim Taleb, the second on who venture capitalist harvest optionality and the third is on Jeff Bezos. Mistakes are essential to harvesting optionality since that is how information is acquired which enables the benefits of optionality to be captured. In his most recent shareholder letter Jeff Bezos writes: “I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there. Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a 10 percent chance of a 100 times payoff, you should take that bet every time.”

 

  1. “Innovations seem inevitable in retrospect, but at the time it’s an uphill battle.”  Wikipedia describes hindsight bias well: “Sometimes called the ‘I- knew-it-all-along’ effect, the tendency to see past events as being predictable at the time those events happened.” Most people say to themselves as they go through life: “Hey I thought of that idea a long time ago.” OK, what the hell did you do actually about it then? Read Kahneman and Thaler on this tendency and you will greatly benefit. People are not always rational and they are not always fully informed. The more you understand this about yourself the fewer mistakes you will make. You can, by paying attention, sometimes find ways to profit when other people act like boneheads.
  1. “People like the idea of innovation in the abstract, but when you present them with any specific innovation, they tend to reject it because it doesn’t fit with what they already know.” Livingston is describing how powerful “person-with-a-hammer-syndrome” can be. The most interesting example I ever saw was how AT&T saw mobile in what I call the early days of mobile telephones. The mobile phone was definitely an innovation. McKinsey in its famous botched study vastly underestimated demand for mobile phones service thinking that no one would use them when they had access to a land line. As Livingston observers, mobile phones did not fit with what McKinsey and AT&T already knew. Even when AT&T bought McCaw Cellular in 1995 they thought they were doing so to save the long distance business. I’m not joking about this. I remember at the time Craig McCaw laughing at this fact and lamenting that he had to sell AT&T the entire business since you can’t partner with a firm that does not understand core product value and the industry itself. AT&T had the cash from its legacy business to pay off the debt used to build the industry so it was felt that the deal needed to be done. AT&T bought McCaw Cellular for the wrong reasons but it was the right decision anyway. Better to be lucky than good, as they say.


  1. “Investors, most of them, have a herd mentality. They want to invest only if other people are investing. It’s like a Catch-22 like not being able to get a job because you don’t have enough experience.” The best and most experienced founders and the better venture capitalist know how to harness this aspect of human nature. People like to do what other people are doing. It is efficient from an informational standpoint. They also like to get in the side car of people who they see as successful. Richard Zeckhauser has written a great paper on this which is well worth reading. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205821 Key bits from the Zeckhauser include: “Most big investment payouts come when money is combined with complementary skills, such as knowing how to develop real estate or new technologies. Those who lack these skills can look for ‘sidecar’ investments that allow them to put their money alongside that of people they know to be both capable and honest.” The critical point is to know when to deviate from the herd. Most of the time the herd is right. The trick is to know when the herd is wrong. Always being a contrarian is suicidal. You must be contrarian and you must also be right about that contrarian view to out-perform the market average.

 

Notes:

Founders at Work:  http://www.amazon.com/Founders-Work-Stories-Startups-Early/dp/1590597141

Most Memorable Quotes from Startup School 2012 http://www.jasonshen.com/2012/the-most-memorable-quotes-from-startup-school-2012

Fortune http://fortune.com/2016/04/04/y-combinator-jessica-livingston/

Founders at Work http://foundersatwork.posthaven.com/what-makes-founders-succeed

Venture Beat http://venturebeat.com/2015/08/23/sam-altman-and-jessica-livingston-explain-y-combinators-success/

TechCrunch Interview http://techcrunch.com/2011/01/26/yc-co-founder-jessica-livingston-on-the-dearth-of-women-in-tech-and-some-steps-to-fix-it /

Business Insider http://www.businessinsider.com/the-advice-for-any-woman-who-wants-to-found-a-startup-2011-1

Interview: The Next Women http://www.thenextwomen.com/?q=2009/05/01/interview-y-combinator-founder-jessica-livingston

Mixergy Interview  https://mixergy.com/interviews/y-combinator-jessica-livingston-interview/

Bloomberg Interview: http://www.bloomberg.com/news/videos/2014-10-10/paul-graham-jessica-livingston-studio-10-1009

The Macro: http://themacro.com/articles/2015/11/jessica-livingston-startup-school-radio/

Paul Graham on Jessica Livingston:  http://paulgraham.com/jessica.html

Startup Grind Interview:   https://www.youtube.com/watch?v=zMZZPiJrBo0

Stanford Interview: https://www.youtube.com/watch?v=syEVbr_2KXQ

Women 2.0 Interview https://www.youtube.com/watch?v=qEceEtgkZFg

Mauboussin: http://www.michaelmauboussin.com/

My post on Paul Graham  https://25iq.com/2014/08/16/a-dozen-things-ive-learned-from-paul-graham-2/

My post on Sam Altman  https://25iq.com/2015/07/17/a-dozen-things-ive-learned-from-sam-altman-about-venture-capital-startups-and-business/

My post on Ann Winblad in which she refers to Mary Gates: https://25iq.com/2014/08/02/a-dozen-things-ive-learned-from-ann-winblad/

 

A Dozen Things I’ve Learned from Chamath Palihapitiya About Investing and Business


 

Chamath Palihapitiya is the founder of the venture capital firm Social Capital. Chamath lived in Sri Lanka until he was 6 when his family moved to Canada. He is a graduate of the University of Waterloo, where he achieved First Class Honors in Electrical Engineering. Chamath was an early member of the Facebook senior management team. He was Facebook’s VP of Growth, Mobile & International. Prior to joining Facebook in 2007 Chamath held senior positions at AOL (Vice President and GM of AIM and ICQ), Mayfield Fund (a venture capital firm in Silicon Valley), Winamp and Spinner.com. He is also an owner of the Golden State Warriors. The mission of Social Capital “is to transform society by using technology to solve the world’s hardest problems.” The venture capital firm’s portfolio includes or has included ownership in businesses like Yammer, SecondMarket, Slack, and Box. Chamath has said: “We’re going to build an organization that looks different than a venture firm. That organization is going to be this hybrid, bastard-stepchild of Berkshire Hathaway and Blackstone and Blackrock. We want to have a large permanent capital base and we want to basically take really long discontinuous bets on companies and sectors and trends.” What I find most interesting about Chamath is the originality of his thinking. Writing this post was harder than usual. No draft has ever changed so much between my first draft and my final post. I re-read and re-listened to a number of the interviews and each time I went back to my draft and made what I had previously written simpler.

The Dozen Things said by Chamath that I selected for this post are:

 

  1. “Most people when they think about growth they think it’s this convoluted thing where you’re trying to generate these extra normal behaviors in people. That’s not what it’s about. What it’s about is a very simple elegant understanding of product value and consumer behavior.” “Winamp [taught me] about core product value. What it means is: create a real connection with someone. I think now we all euphemistically call it the ‘A-ha’ moment with the consumer. But also the power of how these communication networks when they develop create real entrenched usage and scale, and how these things can just dramatically accelerate adoption and engagement.” After all the testing, all the iterating, all of this stuff, you know what the single biggest thing we realized [at Facebook]? Get any individual to seven friends in 10 days. That was it. You want a keystone? That was our keystone. There’s not much more complexity than that.” “It’s not just top-line growth. It’s acquisition, engagement, ongoing product value. It’s understanding the core value and convincing people that may not want to use it.” “What we did at that company was we talked about nothing else. Every Q&A, every all hands nothing was spoken about other than this. Monetization didn’t really come up. Platform came up but again in a secondary or tertiary context. But it was the single sole focus. But because we had defined it in this very elegant way that expressed it as a function of product value it was something that everyone could intrinsically wrap their arms around.” “Knowing true product value allows you to design the experiments necessary so that you can really isolate cause and effect.  As an example, at Facebook, one thing we were able to determine early on was a key link between the number of friends you had in a given time and likelihood to churn. Knowing this allowed us to do a lot to get new users to their ‘A-ha’ moment quickly.  Obviously, however, this required us to know what the ‘A-ha’ moment was with a fair amount of certainty in the first place.”   I stitched this set of quotes together from several sources identified in the Notes below. There are a number of excellent interviews with Chamath on YouTube that I enjoyed watching. I always learn a lot doing the research for these posts but in this case I learned more than usual since he is such an original thinker. In the interviews he repeatedly says that there is no substitute for delivering “core product value” to the customer, which he says is far harder and rarer than most people imagine. He is adamant in his view that metrics measuring factors that do not relate to core product value like the number of invitations sent to friends can be not only distracting but harmful. For Facebook, Chamath says that the keystone was: “get any individual to seven friends in 10 days.” Once that keystone was achieved Facebook customers were receiving enough core product value that they were unlikely to churn and more likely to recommend the service to others because they reached the A-ha moment. If a business does not know what the A-ha moment is for its product in the first place, they are highly unlikely to succeed. Getting distracted by theories about monetization, virality or other factors can be an impediment to creating the scalable connections with customers that create operating leverage. This slide from a presentation by Chamath makes the point about core product value:

 Ah-ha

 

  1. “[At Facebook, to generate growth] we actually just looked at a lot of data, we measured a lot of stuff, we tested a lot of stuff, and we tried a lot of stuff. Now that masks over a lot of more nuanced understanding but at an extremely high level that’s really what we did. What’s shocking to me is when I see a lot of products out there it’s unbelievable to me that people are trying to shroud products in this veneer of complexity. … Measure some shit. Try some shit. Test some more shit. Throw the stuff that doesn’t work. It’s not that complicated.” Chamath is saying that a business must measure the right things if the process is going to be useful. What a business measures as a keystone must capture its core product value. For example, measuring daily active users (DAU) is not the right keystone since it doe snot capture core product value.  Justin Kan sent a tweet recently that said: “Startups mostly don’t compete against each other, they compete against no one giving a shit.” If a business does not deliver core product value no one will care and notifications or invites will be viewed as spam.

 

 Wake-up


  1. “Most people and most companies can barely get one thing right. We all kid ourselves about doing so many different things but there is a value to focus, which is, it constrains optionality and it forces you to have clarity of thinking. Because otherwise what happens is you have all these outcroppings of people within a company that can have their own anecdotal point of view about any kind of random thing. If they practice that rhetoric enough they sound like they know what they’re talking about. Then what happens is you invariably try a bunch of different things and then you end up nowhere. But if you constrain the problem to say there’s one thing. It forces everyone to be an expert or know that one thing, then speak intelligently and most importantly factually about that one thing.” Anyone who has worked at an actual business knows there are always challenges inside EVERY company. Nothing is ever prefect. Maintaining focus is essential. Clarity of thinking and action is powerful when done right. I have written a blog post on Jim Barksdale who likes to say: “The main thing is to keep the main thing, the main thing.” Every business has a profit engine that lies at its core. And that engine is invariably simple if you strip away everything extraneous. Two former Barksdale colleagues write about this about the main thing principle: “We loved that expression when we first heard it from Jim Barksdale, then the COO of FedEx. That single sentence captures the greatest challenge that executives and managers face today: keeping their people and their organizations centered on what matters most.  Every organization needs a Main Thing—a single, powerful expression of what it hopes to accomplish. Without it, it’s not possible to align the four elements that produce organizational efficiency and effectiveness: strategy, people, customers, and processes.”

 

  1. “Users are only ever in three states — they’ve never heard about it; they’ve tried it; and they use it. What you’re managing is state change. So the framework is, what causes these changes? The answer should be rooted more in preference, choice and psychology than in some quantitative thing.” What I want to hear about is the three most difficult and hard problems that any consumer product has to deal with. How to get people on the front door? How to get them to an ‘A-ha’ moment as quickly as possible? And then how do you deliver core product value as often as possible? After all of that is said and done only then can you propose to me how you are going to get people to get more people. That single decision about not even allowing the conversation to revolve around this last thing in my opinion was the most important thing that we did.” “I hate the term ‘growth hacker’. There are a lot of snake-oil salesmen in this field. Let’s not create some wizard-behind-the-curtains thing about this concept called growth hacking. It existed well before me. It’s called product and marketing.” “Most companies in e-commerce right now are negative-gross-margin businesses. Amazon has such enormous scale, and they’re at about 13 or 14 percent gross margins, but on a huge number. In order to compete with Amazon, these businesses have to sell goods for less than what they cost. These companies are in the delivery businesses (Postmates, DoorDash, Instacart) and in the food business (SpoonRocket, Munchery). Basically, a lot of these new-generation, remote-control-type businesses—where the phone acts like a remote control to replace an offline experience—are generally, to date, highly, highly, highly unprofitable. There’s a lot of what I call “venture philanthropy” to prop these businesses up. Time will tell whether any of those can become a real business. If a shoe costs $20, Nike doesn’t sell it for $14. They sell it for $400. We have to get back to this world of having pretty reasonable discipline on business models and understanding that many of these gross-margin businesses will never, never break even or become profitable.” One of the more interesting things happening today in business is how businesses generate these three phase changes Chamath describes above (they’ve never heard about it; they’ve tried it; they use it). Slack CEO Stewart Butterfield said recently: “I think we can get away with not having a sales team in any kind of traditional way probably forever. This is how we have grown so far, and we’d like to continue this forever, which is — people really like it and so they tell other people about it, and then other people start using it. And that’s by far the best because when someone you trust tells you that this thing is good, then you’re much more likely to be inclined to use it.”

 

  1. “1) Approach with humility; 2) Have strong opinions but weakly held; 3). Change your mind a lot; and 4) Experiment and iterate.” Encountering high levels of risk, uncertainty and ignorance is inevitable, especially when it comes to anything related to technology. Being humble is a great way to stay within your circle of competence and avoid other dysfunctional heuristics like over-optimism, person with a hammer syndrome and overconfidence.  Having strong opinions is important since that tends to mean you have developed strong arguments that support your views. But at the same time those strong views should be weakly held because otherwise you may become a victim of dysfunctional thinking approaches like confirmation bias. The justification for changing your mind a lot has to do with being able to profit from optionality. Nassim Taleb has said: “A rigid business plan gets one locked into a preset invariant policy, like a highway without exits —hence devoid of optionality.” Taleb wrote in his book Antifragile: “The idea present in California, and voiced by Steve Jobs at a famous speech: ‘Stay hungry, stay foolish’ probably meant ‘Be crazy but retain the rationality of choosing the upper bound when you see it.’ Any trial and error can be seen as the expression of an option, so long as one is capable of identifying a favorable result and exploiting it.”

 

6. “Success begets more success.” I’ve written about the self-reinforcing nature of success many times. Cumulative advantage is everywhere in the world today if you know how and where to look for it. This “success begets success” phenomenon has always existed, but not in terms of the magnitude of its impact.  Once the world went digital and was increasingly connected by networks, the impact of cumulative advantage was accelerated. Chamath’s life is particularly interesting in no small part because he was involved in one of the most striking versions of cumulative advantage (Facebook) in business history and is funding many other firms through Social Capital that benefit from the phenomenon. Even the Golden State Warriors benefit from cumulative advantage since the more success the basketball team has the more great players (particularly great team players who want to win) want to play there. Additionally, the more success the team has, the more revenues rise, which enables more success [repeat]. A business can generate benefits from cumulative advantage in just the same way as a basketball team. Jack Dorsey said something recently that made me think he believes he can learn a lot about cumulative advantage from this basketball team: “To clear my head, I wake up super-early. I exercise, and have been fascinated by the Golden State Warriors. And I learn a lot from them and their team dynamic. I think what’s really important to me right now in my own leadership is understanding how to build a great team dynamic instead of just hiring a bunch of individuals and heroes. Like, how do we actually build something—a team, and folks who add to the team? And creating a team like the Warriors; that it’s not entirely dependent on one person, but this bench that they have.”

 

  1. “How to pick a VC:  1) Must be a good picker. 2). Must create interest from others for follow-on. 3) Can help you grow.  4) Is morally aligned.” “[A founder] can’t afford to be in a situation where in the absence of operational help you could run out of oxygen.” “You want to have a situation where your venture investors have the benefit of the doubt with other investors.” The reputation of certain venture capitalist has significant signaling effects with other venture capitalists and potential employees. When uncertainty and fear is high, humans have a tendency to form herds and follow pack leaders. The right venture capitalist can get a business through a rough patch. If a business has raise money from a motley crew of investors and there are no leaders, if times get tough or uncertain there may be no one leader to step up and inspire confidence among the other investors or potential new investors. A founder is essentially entering into a marriage with the venture capitalist so it is important to choose well. Chamath has said in several settings that if the founder is not morally aligned with his venture capitalist big problems can result.

 

  1. “The business model of the future is to serve individuals, because individuals are now relatively smarter. That’s not correlated with education, by the way—they are smarter because they have access to tons more information. And so we are all more connected, we are all more engaged, and as a result we are all more cynical. And we all see that the emperor has no clothes. That’s true of banking, that is true of people who run educational institutions, and it’s true of healthcare. So the model of the future is to basically deconstruct all of that and empower the edges. That is the way you build a multi-gajillion-dollar company. Give people individual power.”  This “power to the people” investing thesis is powerful. I wrote about this topic in my profile of Rich Barton on this blog. Providing consumers with information that was formerly locked up in proprietary information systems means information asymmetry ends. Consumers no longer need to be at a disadvantage when purchasing goods and services since they no longer have less information than the provider. Quality goes up. Service levels go up. The bar gets set higher. A big enabler of all of this is the mobile phone. Everyone has access to high quality product information all the time and the result is phenomena like show rooming (looking on line at prices from many vendors when you are in a physical store).

 

  1. “Some companies that we invested in sucked. We were wrong about the market or wrong about the people. But in cases where we were kind of right, then we’ll be really right.” “This is the time when people should be building really big, crazy things.” “It really comes down to a very simple thing, which is, the principle of N of 1 vs. 1 of N.” Venture capital is all about grand slam home runs since the failure rate with startups is high. But it is magnitude and not frequency of success that matters in investing (the Babe Ruth Effect). The failure rate is high enough in the venture business that the math dictates that a very small number of winners will determine whether a particular fund will be financially successful.  Venture capitalists are looking for significant optionality (an asymmetric upside) with a downside limited to what they invest (i.e., you can only lose 1X what you invest but the potential upside is many multiples of what you invest).”

 

  1. “It’s fine to fail. But if you fail because you didn’t have the courage to move to Oakland and instead you burned 30 percent of your cash on Kind bars and exposed brick walls in the office, you’re a fucking moron.” “The company builders are just cheap, they’re just grimy, and just, shitty office space, and they’ve got to keep it under 8 or 9% of their total burn, and they find people who really really believe in the thing they’re making, and they decide to just live in Oakland and pay for Lyft, and it’s still cheaper. They do all kinds of creative things that deserve capital so they can build. So it forces us to ask those questions, ‘How are you really company building?’ And that’s how we get the truth on who’s going to stand the test of time.” “We’re trying to coach our C.E.O.s that the window dressing is both expensive from a cash perspective and tremendously expensive from a culture perspective. It distracts the team from building what they need to build. Don’t waste money on things that get away from your mission, which confuse employees about why they’re actually there. Meaning, the quality of the office and the quality of the food are all part and parcel of a lack of discipline, which speaks to the fact that the mission isn’t compelling enough.” Every penny not spent on achieving the objectives of the business goal is not only wasted but a potentially a contributor to a cash gap that can kill the business. The only unforgivable sin in business is to run out of cash. People who are driven to build a business (missionaries) won’t trade off things like free Kind bars if it increases the risk that they will not achieve their goals. Of course, wasting money is stupid if a founder is more of a mercenary. For example, if a business spends $2,000 on an expensive office chair at seed stage, that chair becomes very expensive indeed if the business eventually has a financial exit at 100X that seed stage valuation.

 

  1. “Poker is a microcosm of my own life.” Michael Mauboussin likes to point to cigar-chomping gambling legend Puggy Pearson to make point about how there are similarities between playing poker and investing:

“Born dirt poor and with only an eighth-grade education (“that’s about equivalent to a third grade education today,” he quipped), Pearson amassed an impressive record: he won the World Series of Poker in 1973, was once one of the top ten pool players in the world, and managed to take a golf pro for $7,000—on the links. How did he do it? Puggy explained, “Ain’t only three things to gambling: Knowin’ the 60–40 end of a proposition, money management, and knowin’ yourself.” For good measure, he added, “Any donkey knows that.”

Charlie Munger ascribes no small amount of his financial success in investing to the time he has spent playing poker and bridge. Munger has said: “The right way to think is the way Zeckhauser plays bridge. It’s just that simple.” At a fundamental level, investing is just one form of making a bet. It’s essential, however, that the bet be made in a way that is investing (net present value positive) rather than gambling (net present value negative). Investing is inherently a probabilistic exercise and experience with other games of chance can be helpful. The great bridge player and Harvard Professor Richard Zeckhauser points out: “Bridge requires a continual effort to assess probabilities in at best marginally knowable situations, and players need to make hundreds of decisions in a single session, often balancing expected gains and losses. But players must also continually make peace with good decisions that lead to bad outcomes, both one’s own decisions and those of a partner. Just this peacemaking skill is required if one is to invest wisely in an unknowable world.” Buffett also believes that bridge shares many characteristics with investing: “Every hand is different and yet what has happened in the past is meaningful. In investing you must make inferences about every bid or card and cards that are not played. Also, as in bridge, you can benefit from having a great partner and having strong interpersonal skills. Understating probability and statistics is essential in both card playing and investing.”

 

  1. [What to look for in a founder] “Very high IQ; Strong sense of purpose; Relentless focus on success; Aggressive and competitive; High quality bar bordering on perfectionism; Likes changing and disrupting things; New ideas on how to do things better; High integrity; Surrounds themselves with good people; Cares about building real value (over perception).” “We try to find businesses that are technologically ambiguous, that are difficult, that will require tremendous intellectual horsepower, but can basically solve these huge human needs in ways that advance humanity forward. Those things don’t necessarily take lots of money, but they generally do take lots of time. And they require really mission-driven people.” This is a great list. There is too much there to talk about everything but on the last point, founders who are mercenaries are not as likely to care about building real value. Missionary founders are naturally aligned with the interests of investors and customers. Creating a startup is such a challenging endeavor that having missionary founders significantly increases the probability that the company will prosper because of this alignment. Chamath puts it this way: “What you value is what you achieve.” Core product value must be the goal instead of short-term optimization if you are going to build a sustainable business.

 

Notes:

Vanity Fair interview:   http://www.vanityfair.com/news/2016/03/chamath-palihapitiya-interview-says-start-ups-are-mostly-crap?mbid=social_twitter

 

Semil Shah Interview of Chamath Palihapitiya:   http://blog.semilshah.com/2015/09/17/transcript-chamath-at-strictlyvcs-insider-series/

 

Chamath Palihapitiya Slide deck:  http://www.slideshare.net/growthhackersconference/how-we-put-facebook-on-the-path-to-1-billion-users

 

Genius transcript of Chamath Palihapitiya: http://genius.com/Chamath-palihapitiya-how-we-put-facebook-on-the-path-to-1-billion-users-annotated

 

Interview of Chamath:  https://www.youtube.com/watch?v=ZlYln36BRpo

 

TechCrunch Interview:  https://www.youtube.com/watch?v=59uTUpO8Dzw

 

StartupGrind Interview: https://www.youtube.com/watch?v=ncjum-bkW98

 

Chamath Palihapitiya on Quora: https://www.quora.com/What-are-some-decisions-taken-by-the-Growth-team-at-Facebook-that-helped-Facebook-reach-500-million-users

 

Wired article:  http://www.wired.co.uk/magazine/archive/2014/09/features/growth-hacking

 

Chamath Palihapitiya Medium post on values:  https://medium.com/@chamath/values-1d00431c35f1#.wbltxp3mu

 

Mauboussin:  http://www.jstor.org/stable/10.7312/maub14372

 

Slack:   http://www.businessinsider.com/slack-ceo-stewart-butterfield-no-salespeople-2016-3?utm_source=dlvr.it&utm_medium=twitter

 

Nassim Taleb blog post: https://25iq.com/2014/04/05/the-best-venture-capitalists-harvest-optionality-dealing-with-risk-uncertainty-and-ignorance/

 

Jim Barksdale blog post:   https://25iq.com/2014/05/31/a-dozen-things-ive-learned-from-jim-barksdale-and-barksdaleisms/

 

Bill Gurley blog post:  https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/

 

Rich Barton blog post:   https://25iq.com/2015/03/01/a-dozen-things-ive-learned-from-rich-barton-about-startups-business-and-investing/

 

Jack Dorsey Interview:  http://www.bloomberg.com/features/2016-jack-dorsey-twitter-interview/

 

 

A Dozen Things I’ve Learned from Dr. Michael Burry about Investing

 

 

Dr. Michael Burry is the founder of Scion Capital. He was recently made famous with the general public as a character in the movie adaptation of Michael Lewis’ book The Big Short, but even before then he was famous in investing circles for his astute investing during times like the financial crisis of 2007. Michael Burry is portrayed in the movie by Christian Bale. The real Michael Burry started out as a part time investor and blogger and built his reputation and AUM with great results and original thinking. He is a physician by training and has diagnosed himself as having Asperger’s Syndrome. Burry is particularly interesting for investors in that he has adapted value investing principles to his personality, skills and nature. Like Charlie Munger did many years before, Burry found new ways for value investing to evolve beyond using the system to find “cigar butt” stocks. Burry’s approach indicates that value investing can work for technology and other stocks that people like Warren Buffet may invest in if circle of competence exists and the holding period is not as long that used by someone like Warren Buffett. Technology changes too much to adopt the same holding period as Munger and Buffett. What is Burry doing today? “Michael Burry is still managing a hedge fund named Scion and is still critical of the way the financial system is being run, but now he’s more interested in water than real estate” wrote the author of a New York magazine article who interviewed him in late 2015. Burry’s story demonstrates several important things. Most importantly, the power of being rational and the power of fundamental bottoms up research. It also demonstrates the huge value that permanent capital provides to a rational money manager since as Keynes once said: Markets can remain irrational longer than you can remain solvent. Even as rational as Burry is, it took courage to make and to hold on to the investments that made him famous. Being right, but too early, is indistinguishable from being wrong.

  1. “My weapon of choice as a stock picker is research; it’s critical for me to understand a company’s value before laying down a dime. I really had no choice in this matter, for when I first happened upon the writings of Benjamin Graham, I felt as if I was born to play the role of value investor.” “Investors in the habit of overturning the most stones will find the most success.” “The late 90s almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane.” Burry has not completely adopted the ideas of Warren Buffett or Ben Graham and has instead developed his own approach that remains true to the fundamental bedrock of value investing. Burry’s example illustrates how it is possible to follow the value investing system and yet have your own unique style. Again, he is at his core a value investor. Burry makes clear in this set of quotes that he treats shares of stock as a partial ownership of a real business and that understanding any business requires research. You must genuinely understand of the underlying business. A share of stock is not a piece of paper to be traded like a baseball card. The movie version of The Big Short conveys that the style of Burry has a lot more stress associated with it than a Buffett approach, but for Burry it has worked out well financially.

 

  1. “All my stock picking is 100% based on the concept of a margin of safety, as introduced to the world in the book “Security Analysis,” which Graham co-authored with David Dodd. By now I have my own version of their techniques, but the net is that I want to protect my downside to prevent permanent loss of capital. Specific, known catalysts are not necessary. Sheer, outrageous value is enough.”  “My firm opinion is that the best hedge is buying an appropriately safe and cheap stock.” “It is a tenet of my investment style that, on the subject of common stock investment, maximizing the upside means first and foremost minimizing the downside.” Burry reveals in these statements that he keeps the core value investing faith by always using a “margin of safety” approach. When Burry says: “Lost dollars are simply harder to replace than gained dollars are to lose” it is another way of saying what Warren Buffett has said many times: “The first rule of investing is: don’t lose money; the second rule is don’t forget Rule No. 1.” Joel Greenblatt agrees: “Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.” Seth Klarman writes in his book of the same name: “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.” An investor who purchases shares in a business at a price that reflects a margin of safety can make a mistake and still do well financially. When Burry refers to “catalysts” he is talking about the events that I wrote about in my post on Mario Gabelli, who has said: “A catalyst may take many forms and can be an industry or company-specific event. Catalysts can be a regulatory change, industry consolidation, a repurchase of shares, a sale or spin-off of a division, or a change in management.” Burry, Buffett, Greenblatt, Klarman, Gabelli all think about margin of safety first. It is not an optional part of value investing.

 

  1. “I try to buy shares of unpopular companies when they look like road kill, and sell them when they’ve been polished up a bit.” “Fully aware that wonderful businesses make wonderful investments only at wonderful prices, I will continue to seek out the bargains amid the refuse.” The third bedrock value investing principle is: Mr. Market is your servant and not your master. Howard Marks makes the same point Burry is making about the necessity of sometime being contrarian: “It is our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling – and if our view turns out to be right – that’s the route to the greatest rewards earned with the least risk…. To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Adopting the popular viewpoint will not result in market out-performance if the popular forecast is also right. Some roadkill is really roadkill, and some refuse is really refuse.  Finding an out-of-favor business selling at a substantial bargain and then waiting is the name of the value investing game. It is easier to say than do.

 

 

  1. “If you are going to be a great investor, you have to fit the style to who you are. At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.… I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.” “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’ I tend to become interested in stocks that by their very names or circumstances inspire unwillingness – and an ‘ick’ accompanied by a wrinkle of the nose on the part of most investors to delve any further.” In his book The Big Short Michael Lewis describes Burry’s view: “The lesson of Buffett is, to succeed in a spectacular fashion you have to be spectacularly unusual.” The movie version of The Big Short certainly portrays Burry as a very usual character due to his Asperger’s syndrome. Burry believes he has an advantage in the investing process since Asperger’s allows him to be more rational/less emotional.  There will be times when Mr. Market will offer up shares in a business at a price that reflects a substantial margin of safety, and to find that bargain wise investors try to find something that is out-of-fashion.  Burry believes there is no better place to look for something that is out-of-fashion than the “ick” category.

 

 

  1. “I prefer to look at specific investments within the inefficient parts of the market.” “The bulk of opportunities remain in undervalued, smaller, more illiquid situations that often represent average or slightly above-average businesses.” “In essence, the stock market represents three separate categories of business. They are, adjusted for inflation, those with shrinking intrinsic value, those with approximately stable intrinsic value, and those with steadily growing intrinsic value. The preference, always, would be to buy a long-term franchise at a substantial discount from growing intrinsic value.” Markets are often efficient but that does not mean that they are always efficient. If you work hard at the research side of investing and are diligent Burry believes that bargains can be found. The bargains may not always be found within your circle of competence and may not be available for very, long but if you are aggressive and willing to act quickly Burry believes there are big opportunities for an investor.

 

  1. “It is Buffett, not Graham that espouses low turnover. Graham actually set targets: 50% gain or 2 years. That actually ensures rather high turnover.” The actual Ben Graham quote from an interview is: “If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price.” This statement by Graham is not consistent with Warren Buffett’s view of the world, but it is perfectly acceptable for a value investor to do as long as the holding period is not so short that it falls within the definition of speculation. Burry feels comfortable buying stocks and other assets that Buffett would avoid. Both approaches are still value investing.

 

 

  1. “Credit-default swaps remedied the problem of open-ended risk for me.  If I bought a credit-default swap, my downside was defined and certain, and the upside was many multiples of it.” Burry is describing a classic example of positive optionality that I discussed in my post on Nassim Taleb: “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).” If you can buy positive optionality at a bargain price that investment can be very valuable. It is of course possible to overpay for optionality.

 

 

  1. “A Scion portfolio will be a concentrated portfolio.”The Fund maintains a high degree of concentration – typically 15-25 stocks, or even less. Some or all of these stocks may be relatively illiquid.” “I like to hold 12 to 18 stocks diversified among various depressed industries, and tend to be fully invested.” Burry is what Charlie Munger calls a “focus investor” since he concentrates his bets. For Burry, owning a small number of stocks in “various depressed industries” is enough diversification. This means he does not buy a dozen health care stocks. In other words, Burry diversifies based on categories.

 

  1. “One hedges when one is unsure. I do not seek out investments of which I am unsure.” It is always wise to have what Charlie Munger calls a “too hard” pile and avoid investment about which you are unsure.  But this approach is especially important if an investor has as few as 12 stocks in their investment portfolio like Burry. One way to make peace with this approach and avoid hyperactive investor syndrome is to realize that you can be a successful investor by making only one of two sound decisions a year. Joel Greenblatt says: “Even finding one good opportunity a month is far more than you should need or want.”

 

  1. “How do I determine the discount? I usually focus on free cash flow and enterprise value (market capitalization less cash plus debt). I will screen through large numbers of companies by looking at the enterprise value/EBITDA ratio, though the ratio I am willing to accept tends to vary with the industry and its position in the economic cycle. If a stock passes this loose screen, I’ll then look harder to determine a more specific price and value for the company. I also invest in rare birds — asset plays and, to a lesser extent, arbitrage opportunities and companies selling at less than two-thirds of net value (net working capital less liabilities). I’ll happily mix in the types of companies favored by Warren Buffett — those with a sustainable competitive advantage, as demonstrated by longstanding and stable high returns on invested capital — if they become available at good prices.”  Burry is not like Buffett in every way and not like Graham either. Burry shows how it is possible to follow the value investing system and yet have your own unique style. But he is still a value investor since he buys at a price that reflects a margin of safety, does not make Mr. Market his master and treats shares of stock as a partial ownership of a real business. Burry’s style is opportunistic and fits with who is he is.  You are not Michael Burry and neither am I. Most everyone is far better off investing in a low cost portfolio of diversified index funds.

 

  1. “Volatility does not determine risk.” “I certainly view volatility as my friend. Volatility is on sale because 99% of the institutions out there are doing their best to avoid it.” “I will always choose the dollar bill carrying a wildly fluctuating discount rather than the dollar bill selling for a quite stable premium.” Michael Mauboussin has a wonderful description of volatility that I like a lot.

 

“A lot of value investors shun concepts such as volatility, or standard deviation, as a measure of risk — and I’m sympathetic to that point of view. That said, the notion of risk is very time-dependent. For very short periods of time, volatility is a pretty good way to think about risk. I have kids in college and I have to write a check for their tuition, so volatility is a very important concept for me. I want to minimize my volatility so I can make sure I can write that check. Or if you go out to an options desk and say, “Options traders, we’re taking away your measure of implied volatility,” they would actually be very much hamstrung. But if you take a long-term point of view, which most value investors do, then that idea of volatility melts away and, in fact, volatility becomes your friend. Risk then becomes the loss of permanent capital. You can bring these under the same tent by thinking about the temporal dimension.”

 

 

  1. “Innovation, especially in America, is continuing at a breakneck pace, even in areas facing substantial political or regulatory headwinds.” Anyone involved in a real business or an occupation like medicine can see the pace of innovation in increasing not decreasing. That people are not buying as much capital equipment like machine tools is not evidence that innovation has slowed. That software is replacing capital goods is obvious to anyone paying attention to the real economy.  Innovation is racing ahead, but not all innovation is profitable. A simple way to think about disruption is to say that it happens when one business is able to harm or eliminate the competitive advantage of another business. It’s that simple. Disruption happens when a business creates innovation which reduces the competitive advantage of rival businesses. Innovation both creates and destroys competitive advantage and therefore profit. Consumers always benefit from innovation. Producers only sometimes benefit from innovation depending on whether the innovation creates or harms a moat.

 

 

Notes:

 

Ben Graham interview in Medical Economics “The Simplest Way to Select Bargain Stocks” September 1976. Ben Graham interview in Medical Economics “The Simplest Way to Select Bargain Stocks” September 1976.  http://blog.alphaarchitect.com/wp-content/uploads/2011/04/Simple-and-Easy-Approach-Medical-Economics-Graham-1976.pdf

 

60 Minutes Interview with Burry https://www.youtube.com/watch?v=blq-1pLGKwc

 

Bloomberg Profile: http://www.hulu.com/watch/333216

 

Vanity Fair Profile: http://www.vanityfair.com/news/2010/04/wall-street-excerpt-201004

 

New York Magazine: http://nymag.com/daily/intelligencer/2015/12/#

 

Wikipedia https://en.wikipedia.org/wiki/Michael_Burry

 

Bustle profile: http://www.bustle.com/articles/133631-what-is-michael-burry-doing-today-the-big-short-character-is-still-weary-of-the-financial

 

My post on Taleb:  https://25iq.com/2013/10/13/a-dozen-things-ive-learned-from-nassim-taleb-about-optionalityinvesting/

 

My post on Greenblatt: https://25iq.com/2015/01/25/a-dozen-things-ive-learned-from-joel-greenblatt-about-value-investing/

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